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BONDS
Just as people need money, so do companies and governments. A company needs
funds to expand into new markets, while governments need money for everything
from infrastructure to social programs. The problem large organizations run into is that
they typically need far more money than the average bank can provide. The solution is
to raise money by issuing bonds (or other debt instruments) to a public market.
Thousands of investors then each lend a portion of the capital needed. A bond is
nothing more than a loan for which you are the lender. The organization that sells a
bond is known as the issuer. You can think of a bond as an IOU given by a borrower
(the issuer) to a lender (the investor.
.For example, say an investor buys a bond with a face value of Rs 1,000, a coupon o
8%, and a maturity of 10 years. This means the investor receives a total of Rs 80 (Rs
1,000 * 8%) of interest per year for the next 10 years. Actually, because most bonds
pay interest semi-annually, the investor receives two payments of Rs 40 a year for 10
years. When the bond matures after a decade, the investor gets your Rs 1,000 back.
The different types of bonds include government securities, corporate bonds,
commercial paper, treasury bills, strips etc. These bonds are either fixed interest bonds
or floating rate bonds. In fixed interest bonds, the interest component remains the same
throughout the tenure of the security. Say a 10-year bond issed today bears 8%
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interest. Even if 5 years hence, the interest rate in the economy goes down to 5%, this
8% bond will continue to earn the investor 8% interest. In a floating rate bond, the
interest rate varies depending on the interst rate of a security that the bond chooses to
benchmark it's interest rate to.
Bond definition :
Bonds are debt and are issued for a period of more than one year. The US government,
local governments, water districts, companies and many other types of institutions sell
bonds. When an investor buys bonds, he or she is lending money. The seller of the
bond agrees to repay the principal amount of the loan at a specified time. Interest-
bearing bonds pay interest periodically.
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TYPES OF BONDS
Bonds have many characteristics such as the way they pay their interest, the market
they are issued in, the currency they are payable in, protective features and their legal
status. Bond issuers may be governments, corporations, special purpose trusts or even
non-profit organizations. Usually it is the type of issuer or the particular nature of a
bond that sets it apart in its own category. We briefly discuss some of the main types
of bonds below:
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THERE ARE MANY TYPES OF BONDS FROM MANY DIFFERENT ISSUERS.
ASSET-BACKED
SECURITIES
GOVERNMENT
BONDS
CONVERTIBLE BONDS
HIGH YIELD
OR "JUNK"
BONDS
CORPORATE BONDS INFLATION-
LINKED BONDS
EUROBONDS
RETRACTABLE
BONDS
FOREIGNCURRENCY
BONDS
ZERO COUPON
OR
"STRIP"BONDS
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ASSET-BACKED SECURITIES
Asset-backed securities are bonds that are based on underlying pools of assets. A
special purpose trust or instrument is set up which takes title to the assets and the cash
flows are "passed through" to the investors in the form of an asset-backed security.
The types of assets that can be "securitized" range from residential mortgages to credit
card receivables.
All asset-backed securities are securities which are based on pools of underlying
assets. These assets are usually illiquid and private in nature. A securitization occurs to
make these assets available for investment to a much broader range of investors. The
"pooling" of assets occurs to make the securitization large enough to be economical
and to diversify the qualities of the underlying assets.
GOVERNMENT BONDS
Supranational Agencies
A supranational agency, such as the World Bank, levies assessments or fees against its
member governments. Ultimately, it is this support and the taxation power of the
underlying national governments that allow these organizations to make payments on
their debts.
National Governments
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The "central" or national governments also have the power to print money to pay their
debts, as they control the money supply and currency of their countries. This is why
most investors consider the national governments of most modern industrial countries
to be almost "risk-free" from a default point of view.
Provincial or State Governments
Provincial or state governments also issue debt, depending on their constitutional
ability to do this.Most investors consider provincial or state issuers to be very strong
credits because they have the power to levy income and sales taxes to support their
debt payments. Since they cannot control monetary policy like national governments,they are considered lesser credits than national governments.
Municipal and Regional Governments
Cities, towns, counties and regional municipalities issue bonds supported by their
property taxes. School boards also issue bonds, supported by their ability to levy a
portion of property taxes for education.
Quasi-Government Issuers
Many government related institutions issue bonds, some supported by the revenues o
the specific institution and some guaranteed by a government sponsor. For example,
The Federal Business Development Bank (FBDB) and the Canadian Mortgage and
Housing Corporation (CMHC) bonds are directly guaranteed by the Federal
government. Provincial crown corporations such as Ontario Hydro and Hydro Quebec
are guaranteed by the Provinces of Ontario and Quebec respectively.
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CONVERTIBLE BONDS
A convertible bond is a bond that gives the holder the right to "convert" or exchange
the par amount of the bond for common shares of the issuer at some fixed ratio during
a particular period. As bonds, they have some characteristics of fixed income
securities. Their conversion feature also gives them features of equity securities.
Convertible bonds are bonds. They have a coupon payment and are legally debt
securities, which rank prior to all equity securities in a default situation. Their value,
like all bonds, depends on the level of prevailing interest rates and the credit quality o
the issuer.
The exchange feature of a convertible bond gives the right for the holder to convert the
par amount of the bond for common shares a specified price or "conversion ratio". For
example, a conversion ratio might give the holder the right to convert $100 par amount
of the convertible bonds of Ensolvint Corporation into its common shares at $25 per
share. This conversion ratio would be said to be " 4:1" or "four to one".
The share price affects the value of a convertible substantially. Taking our example, i
the shares of the Ensolvint were trading at $10, and the convertible was at a market
price of $100, there would be no economic reason for an investor to convert the
convertible bonds. Think of the opposite. When the share price attached to the bond is
sufficiently high or "in the money", the convertible begins to trade more like an equity.
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HIGH YIELD OR "JUNK" BONDS
A high yield, or "junk", bond is a bond issued by a company that is considered to be a
higher credit risk. The credit rating of a high yield bond is considered "speculative"
grade or below "investment grade". This means that the chance of default with high
yield bonds is higher than for other bonds. Their higher credit risk means that "junk"
bond yields are higher than bonds of better credit quality. Studies have demonstrated
that portfolios of high yield bonds have higher returns than other bond portfolios,
suggesting that the higher yields more than compensate for their additional default
risk.
High yield or "junk" bonds get their name from their characteristics. As credit ratings
were developed for bonds, the credit rating agencies created a grading system to reflect
the relative credit quality of bond issuers. The highest quality bonds are "AAA" and
the credit scale descends to "C", and finally to the "D" or default category. Bonds
considered to have an acceptable risk of default are "investment grade" and encompass
"BBB" bonds and higher. Bonds "BB" and lower are called "speculative grade" and
have a higher risk of default.
Rule makers soon began to use this demarcation to establish investment policies for
financial institutions, and government regulation has adopted these standards. Since
most investors were restricted to investment grade bonds, speculative grade bonds
soon developed negative connotations and were not widely held in investment
portfolios. Mainstream investors and investment dealers did not deal in these bonds.They soon became known as "junk" since few people would accept the risk of owning
them.
High yield bond investment relies on credit analysis. Credit analysis is very similar to
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equity analysis in that it concentrates on issuer fundamentals, and a "bottom-up"
process. It is concentrated on the "downside" risk of default and the individual
characteristics of issuers. Portfolios of high yield bonds are diversified by industry
group, and issue type. Due to the high minimum size of bond trades and the specialist
credit knowledge required, most individual investors are best advised to invest through
high yield mutual funds.
CORPORATE BONDS
The creditworthiness of corporate bonds are tied to the business prospects and
financial capacity of the issuer.
The business prospects of companies are dependent on the economy and the
competitive situation of industries. Issuers are grouped by industry, for example real
estate, resource and retail bonds. Industries with stable revenues and earnings are
called "non-cyclicals", where as those whose revenues and earnings rise and fall with
the economy and commodity prices are called "cyclicals".
Issuers are also grouped by their credit ratings. Companies that have financial risk
because of high levels of debt and variable revenues and earnings are called "below
investment grade" or "junk" bonds because of their speculative nature. Higher quality
bonds are considered "investment grade".
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INFLATION-LINKED BONDS
An inflation-linked bond is a bond that provides protection against inflation. Most
inflation-linked bonds, the Canadian "Real Return Bond "(RRB), the British
"Inflation-linked Gilt"and the new U.S. Treasury "inflation-protected security" (IPS)
are principal indexed. This means their principal is increased by the change in inflation
over a period. As the principal amount increases with inflation, the interest rate is
applied to this increased amount. This causes the interest payment to increase over
time. At maturity, the principal is repaid at the inflated amount. In this fashion, an
investor has complete inflation protection, as long as the investor's inflation rate equals
the CPI.
We must compare an inflation-linked bond to a conventional or "nominal" bond to
understand it properly. A normal bond pays its coupon on a fixed principal amount.
Using the Government of Canada 8% bond maturing in 2023 as an example, we are
due 8%, or $8 on every $100 of principal, each year until we are finally repaid our
principal of $100 at maturity. Contrast this with the Canadian RRB, the 4.25%
maturing in 2021. It pays a 4.25% "real" interest rate or $4.25 on its principal each
year. But the principal increases with inflation, which is based on the Canadian CPI.
For example, the CPI, was 1.8% in 1995, the principal amount was increased by 1.8%.
Since its issue in November 1991, the RRB has seen its principal amount increase by
8% to $108. At maturity, when the principal will be repaid by the Canadian
government, the principal amount will have increased to well over $200.
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EUROBOND
A bond issued in a currency other than the currency of the country or market in which
it is issued.
Usually, a Eurobond is issued by an international syndicate and categorized according
to the currency in which it is denominated. A eurodollar bond that is denominated in
U.S. dollars and issued in Japan by an Australian company would be an example of a
Eurobond. The Australian company in this example could issue the Eurodollar bond in
any country other than the U.S.
Eurobonds are attractive financing tools as they give issuers the flexibility to choose
the country in which to offer their bond according to the country's regulatory
constraints. They may also denominate their Eurobond in their preferred currency.
Eurobonds are attractive to investors as they have small par values and high liquidity.
EXTENDIBLE & RETRACTABLE BONDS
Extendible and retractable bonds have more than one maturity date. An extendible
bond gives its holder the right to extend the initial maturity to a longer maturity date.
A retractable bond gives its holder the right to advance the return of principal to an
earlier date than the original maturity. Investors use extendible/retractable bonds to
modify the term of their portfolio to take advantage of movements in interest rates.
The characteristics of these bonds are a combination of their underlying terms. When
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interest rates are rising, extendible/retractable bonds act like bonds with their shorter
terms When interest rates fall, they act like bonds with their longer terms.
Extendible/retractable bonds are created by issuers because they pay a lower interest
rate on these bonds than would otherwise be case or they "sweeten" the issue with this
feature, making the issue easier to sell. Buyers are attracted to these bonds because the
extension or retraction option is attractive to them.
Extendible Bonds
An extendible bond gives its holder the right to "extend" its initial maturity at a
specific date or dates. The investor initially purchases a shorter term bond combined
with the right to extend its term to a longer maturity date. An investor purchases an
extendible bond to have the ability to take advantage of potentially falling interest
rates without assuming the risk of a long term bond. As interest rates fall, the price of a
shorter term bond rises less than the price of a longer term bond. This means the
extendible bond begins to behave or "trade" as a longer term bond. On the other hand,
if interest rates rose, the extendible bond would behave as a shorter term bond.
Retractable Bonds
With a retractable bond, an investor owns a longer term bond with the right to "retract"
it at a specific date. Consider an investor that believes that interest rates will rise and
bond prices will fall, but is not willing or able to sell out of bonds completely. This
investor can buy a longer term retractable bond which behaves initially as a similarterm long term bond. As interest rates rise the bond falls in price. Once its price is low
enough, it will begin to behave as a short term bond and its price fall will be much less
than a normal long term bond. At worst, the investor can retract it at the retraction date
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and receive the par amount back to reinvest.
ZERO COUPON OR "STRIP" BONDS
Zero coupon or strip bonds are fixed income securities that are created from the cash
flows that make up a normal bond.
The cash flows of a normal bond consist of the regular interest or "coupon" payments,
that take place over the term of the bond, and the principal repayment that occurs at
maturity of the bond. For example, the cash flows of the Government of Canada 8%bond with a maturity date of June 1, 2023 are:
$4 every December and June 1st up to and including June 1, 2023, representing 4% o
the $100 par value; and
$100 on June 1, 2023, representing the repayment of the principal or par amount of the
bond
Taken individually, each of these payments is an obligation of the issuer, in this case,
the Government of Canada. The process of "stripping" a bond involves deppositing
bonds with a trustee and having the trustee separate the bond into its individual
payment components. This allows the components to be registered and traded as
individual securities. The interest payments are known as "coupons" after their source
of cash flow, and the final payment at maturity is known as the "residual" since it is
what is left over after the coupons are stripped off. Both coupons and residuals are
known as "zero coupon" bonds or "zeros".
Conceptually, a zero coupon security is just like a Treasury Bill or "T-Bill". The
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investor pays something up front in exchange for a promise to receive $100 on the
maturity date. Take our example of the coupons and residual generated by stripping
the Canada 8% of 2023. If we start on December 1, 1996 the first two payments are
identical to a 6 month and 1 year T-Bill. An investor would receive $100 on June 1st
and December 1st for each $100 par amount she purchased of these terms of coupons.
The longer coupons get a bit more complicated. Take the coupon due on December 1,
2001, five years from December 1, 1996. What do we pay for this $100? First of all,
we need to consider what interest rate would be appropriate. Reflecting on the term
structure of interest rates, we know that we should use the yield on a similar term
Government of Canada bond. Being bond market fans, we just happen to know that
there is a Government of Canada issue the 9.75% of December 1, 2001. We also know
that it currently yields 5.6% semiannually.
FOREIGN CURRENCY BONDS
A "foreign currency" bond is a bond that is issued by an issuer in a currency other than
its national currency. Issuers make bond issues in foreign currencies to make them
more attractive to buyers and to take advantage of international interest rate
differentials. Foreign currency bonds can "swapped" or converted in the swap market
into the home currency of the issuer. Bonds issued by foreign issuers in the United
States market in U.S. dollars are known as "Yankee" bonds. Bonds issued in British
pounds in the British bond market are known as "Bulldogs". Yen denominated bonds
by foreign issuers are known as "Samurai" bonds.
The "euromarket" is another major source of foreign currency bond issues. European
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investors will buy the bonds of well known issuers like Ford, Toyota or General
Electric or their international subsidiaries, in many different currencies depending on
their currency views.
Foreign currency bonds have a vocabulary all their own. Bonds issued in foreign
currencies are given the names listed beside the currencies below:
"Yankee Bonds" for U.S. dollar
"Samurai Bonds" for Japanese Yen
"Bulldog Bonds" for British pounds; and
"Kiwi Bonds" for New Zealand dollars
Foreign currency bonds have a much different risk and return profile than domestic
bonds. Not only is their price affected by movements in a foreign country's interest
rate, they also change in value depending on the foreign exchange rates. In Canada, for
example, the Canadian dollar has moved upwards to 4% in U.S. dollar terms in veryshort periods of time. This exchange rate movement would result in price changes o
4% in Canadian dollars which completely overwhelms the coupon income of a bond.
Studies have shown that the longer term risk and return characteristics of foreign
bonds in domestic currencies are closer to domestic equity returns than domestic fixed
income returns.
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Every fund's prospectus outlines important information that can help you find the
fund that may be right for you. The characteristics explained below are important
factors that can help you evaluate your bond fund investment. Prospectuses for
both Fidelity funds and FundsNetwork funds can be found in Products > Mutual
Funds. Or use the Fund Evaluator to find a fund that meets the criteria.
Investment Goals
Bond funds have specific investment goals, such as pursuing high income or
preservation of capital. Bond funds may follow different investment guidelines in
order to pursue those goals. For example, some funds may limit their investments
to U.S. government and government agency investments while other funds may
invest in different bond sectors including corporate, government, government
agency, and mortgage-backed bonds. The prospectus will state the fund's goals
and investment guidelines.
Average Maturity
A bond fund maintains a dollar-weighted average maturity, which is the average o
all the current maturities of the individual bonds in the fund. The longer the
average maturity, the more sensitive the fund will be to changes in interest rates.
Funds with "short-term," "intermediate-term," or "long-term" in their names
indicate the average maturity the fund targets.
EVALUATING A BOND FUND
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Duration
Duration estimates how much a bond's price fluctuates with changes in
comparable interest rates. If rates rise 1.00%, for example, a fund with a 5-year
duration is likely to lose about 5.00% of its value. Other factors also can influence
a bond fund's performance and share price. A bond fund's actual performance may
differ.
Credit Quality
The average credit quality of a bond fund will depend on the credit quality of the
underlying securities in the portfolio. Bond credit ratings can range from
speculative to very high credit quality. Bonds rated medium to high credit quality
are commonly referred to as "investment grade-quality." Bonds rated below
investment grade-quality are commonly called "high yield" bonds or "junk" bonds.
Funds that invest in lower-quality securities have the potential for higher yields
and returns, but will also likely experience greater share price volatility.
The credit quality of a bond is reflected in ratings assigned by independent rating
companies such as Standard & Poor's and Moody's. These rating companies use a
letter scale to indicate credit quality, with the highest credit quality being AAA.
Bonds in default are assigned C and D ratings. This rating system can give
investors important information on the creditworthiness of a bond.
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Performance
It's important to look at a fund's total return over time. Total return takes into
account the value (or price) of the underlying bonds held by the fund in addition to
income distributions from those bonds. Investors interested in income may want to
look at the fund's 30-day yield. However, keep in mind that yield by itself does not
tell the entire story. Higher yields usually come with strings attached. For
example, the fund may achieve higher yields through investments in lower-quality
securities, which may make the share price (or value) of your bond fund
investment more volatile.
Expenses and Fees
All mutual funds have operating expenses that include the costs of managing a
fund. Some bond funds have sales charges, or loads, that are deducted from the
amount of your initial investment. Some funds may charge a redemption fee for
shares sold within a certain time period. Others may charge a small annual account
fee. Make sure you are aware of all expenses before you invest.
Fund Management
Bond markets today are more complex than they were just a few years ago. In
selecting a mutual fund company for your bond fund investments, make sure the
company is committed to providing the research and analysis that bond fund
management now requires.
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BASICS FOR TRADING BONDS
Auction Market-Bid/Ask/Spread - Bonds like stocks trade on an auction market
thus, they have a bid, the highest price offered to buy a bond, and an ask, the
lowest price a seller hopes to get for their bonds. Most trades take place
somewhere between these two prices.
Quantity - The prices quoted are usually for trades of $20,000 (20 Bonds) or
higher. When buying bonds in smaller quantities an investor will commonly have
to pay a higher price than the ask price. The reverse is true when selling a bond in
the secondary market; the price you receive may be lower.
Identifying a Bond - When requesting a quote or placing an order for a bond be
sure to carefully identify the bond completely by using: issuer, coupon rate,
maturity date and, as an added precaution, the CUSIP number. Also include the
number of bonds you want to buy or sell. Remember, 10 bonds represents $10,000
face value of securities.
Exchange Traded Bonds - Exchange traded bonds are much easier to buy and sell
than OTC or unlisted issues. Most full service and discount brokerage firms will be
able to place an exchange order. Make sure you tell the broker that it is an
exchange- traded bond, they often won't know this. B e f o re you place an order
ask for a quote. Identify the bond by: issuer, coupon rate, maturity date and as an
added precaution the CUSIP number. Include the number of bonds you want to
buy or sell. Agreeing to the ask price quoted should ensure your buy, however, you
can also place a bid at a lower price. When selling a bond you can offer it at the bid
price or enter a new ask price. When submitting new bids be reasonable and make
it near the market price. Have patience, the more liquid a bond is the better chance
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for an early execution. Many investors place Good Till Cancelled order for bonds,
but don't forget that you have placed the order.
Not Listed (OTC) Bonds - OTC bonds are difficult to buy and sell in small
quantity. Most discount brokers will not shop for a specific bond. Thus, if it is not
in their inventory, chances are an investor will not be able to execute an order. The
sell side is also difficult for small quantities. Full service firms look beyond their
own inventory however this does not guarantee an execution. Price quotes are very
important and if it is possible multiple quotes should be obtained before placing
and order. Be careful, don't chase a bond and watch for big spreads. It is best to
specify a bid when buying and an offering or ask price when selling.
Accrued Interest - The amount of interest accumulated but not paid between the
most recent payment and the sale of a bond. When purchasing bonds on the
secondary market, this is the interest the former owner earned but has not been
paid. It will be added to the buy price of a bond and be paid to the seller. The new
buyer will receive the full semiannual interest payment on the next pay date.
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Bonds' Risks and Potential Return
As with any investment vehicle, the higher the potential for return, the higher the
risk.
Bond yields reflect the issuer's credit quality as well as the fund's maturity. Lower-
quality investments generally offer higher yields than higher-quality issues but
may be more volatile. The higher yield compensates the investor for lending
money to a company or municipality that is considered more likely to default that
is, not make timely interest or principal payments. This is called credit risk.
The possibility that interest rates will rise after you purchase a fixed-income
security is called interest rate risk, which is another risk factor and is explained in
detail below.
Interest Rates Affect Bonds
When interest rates rise, the value of existing bonds and bond fund shares
generally will decline. Conversely, when interest rates fall, the value of bond and
bond fund shares generally will rise. Since it is difficult to predict whether interest
rates will go up or down, T. Rowe Price believes you should create a broadly
diversified bond portfolio that is appropriate for your investment goals.
We do not recommend changing your bond portfolio mix in anticipation of rising
or falling rates. However, investing in several bond funds with different investment
strategies can help cushion the effects of interest rate risk and credit risk on your
overall portfolio. For example, investing in both shorter and longer maturities can
help your strategy stay on track during both high and low interest rate climates.
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Income Earned by Bond Funds
To understand how bond funds earn money amid changing market conditions,
we've illustrated some key principles below.
A bond's coupon rate is the bond's fixed rate of interest expressed as a percentage
of its face value (also known as par value) which is normally $1,000. Longer-term
and lower-quality bonds generally have higher coupon rates than shorter-term and
higher-quality issues. Among taxable investments, U.S. Treasury securities carry
the lowest coupon rates because the federal government is the nation's most
creditworthy borrower. Since most bonds pay interest semiannually, a bond with aface value of $1,000 and an 8% coupon rate pays $40 twice a year, for a total of
$80 per year.
While the coupon rate of a bond is fixed, its current yield can fluctuate with risingand falling interest rates that are dictated by market conditions. This is how interest
rate risk can affect a bonds total return.
You can figure out the current yield by dividing the interest paid each year by the
current price of the bond.
A bond paying $80 interest per year yields 8% at par value. But if interest rates rise
in the market, causing the bonds price to fall to $900, the current yield rises to
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8.9% ($80/$900 = 8.9%). If the value of the bond rises to a premium over par, say
to $1,100, the current yield drops to 7.3% ($80/$1,100 = 7.3%).
If you hold a bond until it matures, the bonds compound annual rate of return is
made up of two components: interest income and capital gain or loss. An 8% bond
bought at a price of $900 and held until it matures in 10 years generates income of
$800 and a capital gain of $100. Your average annual return, assuming all interest
payments are reinvested at the same rate, is called the yield to maturity.
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Credit Ratings
Rating services (such as Moody's or Standard & Poor's) evaluate how likely a bond
issuer is to repay the debt and interest on time. A bond rated AAA/Aaa is the mostcreditworthy, while a bond rated BB/Ba or below is much riskier.
An established, reputable company might have bonds carrying an investment-grade
rating such as AA (with a low yield but a lower risk of default), while bonds issued
by a company with a high debt level or other financial vulnerability might have a
low rating. These lower-grade, high-yield bonds have a higher return potential but
also a higher risk of default.
Bond Rating Codes
RATINGSTANDARD &
POORSMOODYS
Highest quality AAA Aaa
High quality AA Aa
Upper-medium quality A A
Medium grade BBB Baa
Somewhat speculative BB Ba
Low grade speculative B B
Low grade (default possible) CCC Caa
Low grade (partial recovery
possible) CC Ca
Default (recovery unlikely) C C
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Portfolio Management
Meaning of Portfolio Management
The art and science of making decisions about investment mix and policy,
matching investments to objectives, asset allocation for individuals and
institutions, and balancing risk against. performance.
Portfolio management is all about strengths, weaknesses, opportunities and threats
in the choice of debt vs. equity, domestic vs. international, growth vs. safety, andmany other tradeoffs encountered in the attempt to maximize return at a given
appetite for risk.
Portfolio Management
In the case of mutual and exchange-traded funds (ETFs), there are two forms of
portfolio management: passive and active. Passive management simply tracks a
market index, commonly referred to as indexing or index investing. Active
management involves a single manager, co-managers, or a team of managers who
attempt to beat the market return by actively managing a fund's portfolio through
investment decisions based on research and decisions on individual holdings.
Closed-end funds are generally actively managed.
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BOND PORTFOLIO MANAGEMENT
BANKS IN INDIA, generally invest in bonds issued by both the Central and State
Government and their agencies. Investment in corporate debt is also increasingly
becoming popular. Banks may invest in all types of bonds and of varying
maturities and are expected to manage the interest rate risk arising from this
investment by adopting suitable assets liability management policies. Further,
certain privately placed Non- SLR Bonds will be treated at par with Advances and
be subjected to all prudential norms relating to advances. A typical banks
investment portfolio would consist of all types of bonds and possibly equity shares
also.
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Legal Framework Governing Securities
Reserve Bank Of India is entrusted with the regulation of transactions in
Government securities, money market Securities, gold related securities and repo
in all instruments. In particular, aspects relating to Government Securities are
covered under the Public debt Act and Rules and Notification under the Public debt
Act, issued by both Central and State Governments. As regardes Corporate bonds,
provision contained in Securities contracts (Regulation) Act , Depositories Act ,
Stock Exchange Bye laws and the terms and conditions of issues of the individualbonds are relevant .
Investment and trading activities of bank in bond should conform with the
regulations issued by RBI on classification and valuation in addition to under legal
provision mainly contain in Securities Contracts (Regulation) Act. The RBI
Regulationare mainly prudential. Accordingly banks are required to categories the
investment in to three, viz,Held To Maturity (HTM), Held for Trading(HFT)and Available For Sale(AFS). HTM not to exceed 25% of the investments. HFT
should be subjectt to the discipline and controls required for trading. AFS ciontains
investments which are in neither HTM nor HFT categories. Categorisation is based
on the jintensinon if the bank at the time of purchase of the security and shifting
between categories is permissible only exceptionally. There are striggent rules for
shifting between categories. Banks are not excepted to take any unrrealised gain to
income account, but provide for all losses on a mark-to-market basis. While HTM
investments need not be marked to market, HFT and AFS should be marked to
market. RBI also has stipulated that banks should maintain an Investment
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Fluctuation Reseerve and build up adequate reserves out of realised gains every
year.
While the above are some of the salient features of the RBI instructions,
Investments jmangagers in banks hsould be fully conversant with the instructions
issued by RBI from time to time regarding the procedural and regulatory aspects
relating to investments.
In addition, it is necessary to take into consideration the management perspectives
on returns and risk management. The organisational structure for treasury
management also has an important bearing on the conduct of bond portfolio
management on safe and sound lines.
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Banking Book and Trading Book
The Investment policy is the document approved by the top management of a bank
articulating the investment objectives, risk management aspects etc. Banks can
adopt both passive or active approaches to management of their portfolios and the
banks investment policy should specify the banks approach. The passive
approach is usually identified with buy-and-hold strategy. Active bond portfolio
management involves switching and swapping bonds as circumstances change in
the market.
Investments are categorised on the basis of the banks intent at the time of
acquistion of securities. i.e. whether it is meant to be held till maturity (Held To
Maturity) or sold. A further differentiation is possible is respect of the securities
acquired for safe: whehter they are intended to be available for sale at an
appropriate time depending on the banks liquidity needs (Available for Sale) or
whether they are intended for operations (purchase and sale of securities with a
view to take advantage of the expected movement in their market prices). Those
securities purchased with the intension of trading have tdo be classified as Held
for Trading and are subject to regulatory prescriptions regarding holding period,
stop-loss etc. The aggregation of such securities held for trading forms the
Trading Book of the bank. A bank which decides to maintain a trading book is
expected to have in place proper risk management, trading policies, delegation of
powers, skills, dealing infrastructure etc. Basel Committees capital adequacy
norms prescribe maintenance of capital to cover market risk in the Trading Book.
Securities, other than those in the trading book, are classified as belonging to the
Banking Book. In the case of Banking Book the securities are treated on par
with the other assets as far as balance sheet risks are concerned.
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Bond Portfolio Management Strategies
Stock market investors will choose a particular risk level on the SML and invest at
this point, choosing only those securities that lie on the SML (or above it). Stockinvestors have different levels of risk/return requirements Bond investors will do
the same thing. A young, aggressive bond investor may choose a high risk bond &
is willing to risk his principal investment. A retiree may not be willing to take a
risky bond investment and may, instead invest in conservative bonds.
Individual investors choose to invest in bonds. Also, pension plans, banks,
insurance companies and other institutions invest in bonds. At any rate, all
investors are interested in a bond investment strategy. There are three major types
of strategies:
1.passive portfolio management strategies2. active portfolio management strategies3. matched-funding strategies
In the 1950s the bond market was considered a safe, conservative investment. At
that time a buy-and-hold strategy was sufficient. However, times changed, in the
1960s inflation increased, and interest rates became more volatile. Thus, with more
volatile interest rates, there was a great amount of profit potential with bonds.
Also, in the 1970s the Macauley duration measure was re-discovered.
Not all investors viewed the rise in interest rate volatility as a good thing. The
pension fund and insurance companies that invest in bond found their job much
more difficult. Thus, strategies based on duration were developed to aid pension
fund managers to match their liabilities with properly constructed bond portfolios.
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Passive Bond Portfolio Strategies
There are two major passive strategies:
y buy-and-holdy indexing
Buy-and-hold Strategy
This strategy simply involves buying a bond and holding it until maturity. Bond
investors would examine such factors as quality ratings, coupon levels, terms to
maturity, call features and sinking funds. 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 buy bonds with
the intention of holding them until maturity, but they still actively look for
opportunities to trade into more desirable positions. [However, if you modify this
too much it turns into an active strategy.]
While the buy-and-hold strategy is a passive strategy, it still involves a great deal
of work. Agency issues typically provide high quality bonds at a higher return than
Treasury securities, callability affects the attractiveness of an issue, etc. Plus, you
may want to develop a portfolio in which coupon payments are structured (and
principal repayments).
Techniques, Vehicles and Costs: Only default-free or very high quality securities
should be held. Also, those securities that are callable by firm (allows the issuer to
buy back the bond at a particular price and time) or putable by holder (allows
bondholder to sell the bond to issuer at a specified price and time) will introduce
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alterations in the firm's cash flows, and probably should not be included in the buy-
and-hold strategy. Also, those investors seeking to lock in a rate of return may
choose a zero-coupon bond--good strategy for college tuition or retirement. The
buy-and-hold strategy minimizes transaction costs and, if implemented astutely,
can be highly productive. For example, if interest rates are currently high and are
expected to remain so for an extended period of time, the buy-and-hold strategy
will do well.
Indexing
Indexing involves attempting to build a portfolio that will match the performanceof a selected bond portfolio index, such as the Shearson Lehman Hutton
Government/Corporate Bond Index, Merrill Lynch Index, etc. This portfolio
manager is judged on his ability to track the index.
Techniques, Vehicles and Costs: The fixed income market is broader (in terms of
security types) than the equity market. Also, even though the Shearson Lehman
Hutton Corporate Bond Index has over 4,000 securities, it only represents high
quality corporate bond issues. Thus, a compromise must be made when selected
among different indexes. Also, the strategy of buying every bond in a market index
according to its weight in the index is not a practical one. However, a relevant
subset is possible. We may choose to emulate a narrower bond index.
Alternative Vehicles: We may choose to randomly select bonds from the universe
of bonds, or, we may choose the stratified approach (segmenting the index into
components from which individual securities are chosen). When choosing the
indexing option, bond portfolio management cannot be considered entirely passive.
Also, there will be transaction costs associated with (1) purchasing the issues used
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to construct the index; and (2) reinvesting cash payments from coupon and
principal repayments; and (3) rebalancing of portfolio if the composition of your
target index changes. Whereas full replication of the target index would work best,
this is impractical. If you choose the stratified method, your performance will
probably not mirror your target index.
How many securities should you have in your portfolio if you use the random
sampling approach? McEnally and Boardman (1979) have found that, once an
index is selected, close replication is possible with perhaps 40 bonds (for the long
term).
Stratified Approach: Consists of analyzing the index to determine various
stratification levels (what portion of securities that make up index are Treasury,
Aaa Industrial, Baa Financial, of X years to maturity, of X% coupon rate, etc.).
The next step is to select the securities for your portfolio. Typically, at selection
and at the rebalancing period (usually once a month) one security is chosen from
each category (there could be 40 categories). There's no requirement as to which
security is selected from each class.
Active Management Strategies
These strategies require major adjustments to portfolios, trading to take advantage
of interest rate fluctuations, etc. There are four major active bond portfolio
management strategies:
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1. Interest rate anticipation2. Valuation analysis3. Credit analysis4. Yield spread analysis
In each strategy, the manager hops to outperform the buy-and-hold policy by using
acumen, skill, etc.
Interest Rate Anticipation
This is the riskiest strategy because the investor must act on uncertain forecasts of
future interest rates. The strategy is designed to preserve capital (lose as little as
possible) when interest rates rise (and bond prices drop) and to receive as much
capital appreciation as possible when interest rates drop (and bond prices rise).
These objectives can be obtained by altering the maturity or duration of their
portfolios. Longer maturity, or longer duration, portfolios will benefit the most
from an interest rate decrease and vice versa. Thus, if a manager expects an
increase in interest rates, they would structure portfolio to have the lowest possible
duration.
The problem faced with this type of strategy is the risk of mis-estimating interest
rate movements. It is difficult (EXTREMELY) to predict (with accuracy) interest
rate movements.
However, if this is your strategy, you should be concerned with:
y direction of the change in interest rates
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y the magnitude of the change across maturities, andy the timing of the change.
How your bond will be affected by changes in interest rates can usually be directly
related to the security's duration. Thus, if you expect IR to drop, you should shift to
high duration securities. Also, the timing as to when you expect the interest rate
shift is important. You don't want to shift too early, because you may compromise
some return. Obviously, you don't want to wait too late.
Scenario Analysis: Say, "what if" interest rates rise/fall by this much over the next
month/year/etc. Analyze the individual bonds within your portfolio under eachscenario and see how the returns are affected under each scenario. [See p. 8-30]
The scenario analysis leads us to further analysis.
Relative Return Value Analysis: We can calculate the overall expected return for
each bond in our scenario (expected return under each interest rate scenario
weighted by the probability of that scenario occurring) and the current duration of
each bond in our portfolio and graph the relationship. Those bonds falling above a
regression line (showing the general relationship) would be doing ok!
Strategic Frontier Analysis: We can graph the bonds in our portfolio with the
best case scenario (an interest rate decrease) on the vertical axis and the worst case
scenario on the horizontal axis, as shown below:
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Those securities which fall into Quadrant I represent aggressive securities--if the
best case happens, they will do well; however if the worst case happens they will
be the worst performers. Those securities falling into Quadrant II are superior
securities--they will perform well regardless of which scenario occurs. Quadrant III
represents defensive securities--they will do well under the worst case scenario, but
perform poorly if the best case occurs. Quadrant IV securities are inferior as they
will perform poorly regardless of the scenario. You should sell securities falling
into Quadrant IV. Normally a few securities would fall into Quadrants II and IV,
with most falling into Quadrants I and III.
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Valuation Analysis
The portfolio manager looks for undervalued bonds--those bonds that have a
computed value (according to the portfolio manager) higher than the current
market price). This also translates to those bonds whose expected YTM is lower
than the current YTM. This strategy requires lots of analysis (continuous
evaluations) and lots of trading based on the analysis. Based on your confidence in
your analysis, you would buy undervalued bonds and sell overvalued bonds (or
ignore them if they are not in your portfolio).
Valuation Analysis: We can examine the term structure of pure discount bonds
(zero coupon) and thus determine the value of US Treasuries, thus we can
determine the default free characteristics of any other type of bond. Then we can
attempt to determine the other factors that will affect bond yield by using multiple
factor regression analysis (looking at things such as: quality rating, coupon effect,
sector effect, call provision, sinking fund attributes, etc.) Using this factor analysis,
we can determine the expected yield for the security (if the expected yield