Types and Structure of

Debt Instruments

Bonds
Bonds refer to debt instruments bearing
interest on maturity.
Bonds have a maturity period of more
than one year.

Features of Bonds
The most important features of a bond are:
Interest
Maturity
Credit rating

TYPES OF BONDS
Municipal Bonds:
Municipal bonds are debt obligations issued by
states, cities, countries and other governmental
entities.
used for building schools, highways, hospitals,
sewer systems, and many other projects for the
public good.

Government Bonds:
Government Bonds are securities issued by the
Government for raising a public loan or as notified in
the official Gazette.
They consist of Government Promissory Notes,
Bearer Bonds, Stocks or Bonds held in Bond Ledger
Account.
Issued by RBI

Corporate Bonds
Corporate bonds are debt obligations issued by
private and public corporations.
When you buy a bond, you are lending money to
the corporation that issued it.
The interest payments you receive from corporate
bonds are taxable.

Risk and Returns for

Equity Shares

Returns from the Equity shares

1.

2.

MONETARY BENEFITS
Capital Appreciation
Dividend
NON-MONETARY BENEFITS
Bonus shares
Right Issue

Risk associated with Equity shares

Market/ Economy risk

Industry risk
Management risk
Finance risk
Exchange rate risk

Risk and Returns for

Debt Securities

Risk associated with Debt securities

Credit Risk or Risk of default

Interest rate risk
Liquidity risk
Inflation risk
Sovereign risk

Returns on Debt securities

Zero Coupon Bonds

Zero coupon bonds are bonds that do not pay interest during the life of the bonds.
Instead, investors buy zero coupon bonds at a deep discount from their face value,
which is the amount a bond will be worth when it "matures" or comes due. When a
zero coupon bond matures, the investor will receive one lump sum equal to the
initial investment plus the imputed interest, which is discussed below.
The maturity dates on zero coupon bonds are usually long-term. These long-term
maturity dates allow an investor to plan for a long-range goal, such as paying for a
childs college education. With the deep discount, an investor can put up a small
amount of money that can grow over many years.
The price of a zero-coupon bond can be calculated by using the following formula:

How is the Zero Coupon Bond Effective Yield Formula Derived?

The formula for calculating the effective yield on a discount bond, or zero coupon
bond, can be found by rearranging the present value of a zero coupon bond
formula:

where: F = Face value r = investor's required annual yield / 2

t = number of years until maturity x 2
This formula can be written as

This formula will then become

By subtracting 1 from the both sides, the result would be the formula

Risks of Investing in Bonds

Interest rate risk When interest rates rise, bond prices fall; conversely, when rates
decline, bond prices rise. The longer the time to a bonds maturity, the greater its
interest rate risk.
Reinvestment risk When interest rates are declining, investors have to reinvest
their interest income and any return of principal, whether scheduled or unscheduled,
at lower prevailing rates.
Inflation risk Inflation causes tomorrows rupee to be worth less than todays; in
other words, it reduces the purchasing power of a bond investors future interest
payments and principal, collectively known as cash flows. Inflation also leads to
higher interest rates, which in turn leads to lower bond prices.
Market risk The risk that the bond market as a whole would decline, bringing the
value of individual securities down with it regardless of their fundamental
characteristics.
Default risk The possibility that a bond issuer will be unable to make interest or
principal payments when they are due. If these payments are not made according to
the agreements in the bond documentation, the issuer can default

Call risk Some corporate, municipal and agency bonds have a call provision entitling
their issuers to redeem them at a specified price on a date prior to maturity. Declining
interest rates may accelerate the redemption of a callable bond, causing an investors
principal to be returned sooner than expected. In that scenario, investors have to
reinvest the principal at the lower interest rates.
If the bond is called at or close to par value, as is usually the case, investors who paid
a premium for their bond also risk a loss of principal. In reality, prices of callable bonds
are unlikely to move much above the call price if lower interest rates make the bond
likely to be called.
Liquidity risk The risk that investors may have difficulty finding a buyer when they
want to sell and may be forced to sell at a significant discount to market value.
they are due and therefore default.
Event risk The risk that a bonds issuer undertakes a leveraged buyout, debt
restructuring, merger or recapitalization that increases its debt load, causing its bonds
values to fall, or interferes with its ability to make timely payments of interest and
principal. Event risk can also occur due to natural or industrial accidents or regulatory
change. (This risk applies more to corporate bonds than municipal bonds.)

Credit Rating Agencies rate the debt instruments of companies. They do not rate
the companies, but their individual debt securities. Rating is an opinion regarding the
timely repayment of principal and interest thereon; It is expressed by assigning
symbols, which have definite meaning. A rating reflects default risk. Ratings are
not a guarantee against loss. They are simply opinions based on analysis of the risk
of default. They are helpful in making decisions based on particular preference of risk
and return. A company, desirous of rating its debt instrument, needs to approach a
credit rating agency and pay a fee for this service.
The determinants of ratings
The default-risk assessment and quality rating assigned to an issue are primarily
determined by three factors i) The issuer's ability to pay: Ratio analysis is used to analyse the present and future
earning power of the issuing corporation and to get insight into the strengths and
weaknesses of the firm.
ii) The strength of the security owner's claim on the issue: To assess the strength of
security owner's claim, the protective provisions in the indenture (legal instrument
specifying bond owners' rights), designed to ensure the
safety of bondholder's investment, are considered in detail.
iii) The economic significance of the industry and market place of the issuer: The
factors considered in regard to the economic significance and size of issuer includes:
nature of industry in which issuer is, operating (specifically issues like position in the
economy, life cycle of the industry, labour situation, supply factors, volatility etc.), and
the competition faced by the issuer (market share, technological leadership,
production efficiency, financial structure, etc.)

RATING METHODOLOGY
Key areas considered in a rating include the following:
i) Business Risk : To ascertain business risk, the rating agency considers
Industry's characteristics, performance and outlook, operating position (capacity,
market share, distribution system, marketing network, etc.), technological
aspects, business cycles, size and capital intensity.
ii) Financial Risk : To assess financial risk, the rating agency
takes into account various aspects of its Financial Management (e.g. capital
structure, liquidity position, financial flexibility and cash flow adequacy, profitability,
leverage, interest coverage), projections with particular emphasis on the components
of cash flow and claims thereon, accounting policies and practices with particular
reference to practices of providing depreciation, income recognition, inventory
valuation, off-balance sheet claims and liabilities, amortization of intangible assets,
foreign currency transactions, etc.
iii) Management Evaluation : Management evaluation includes consideration of
the background and history of the issuer, corporate strategy and philosophy,
organizational structure, quality of management and management capabilities under
stress, personnel policies etc.
iv) Business Environmental Analysis : This includes regulatory environment,
operating environment, national economic outlook, areas of special significance to
the company, pending litigation, tax status, possibility of default risk under a variety
of scenarios.

CREDIT RATING AGENCIES IN INDIA

CRISIL : This was set-up by ICICI and UTI in 1988, and rates debt instruments.
Nearly half of its ratings on the instruments are being used.
CRISIL evaluation is carried out by professionally qualified persons and
includes data collection, analysis and meeting with key personnel in the company to
discuss strategies, plans and other issues that may effect ,evaluation of the
company. The rating ,process ensures confidentiality. , Once the company decides
to use rating, CRISIL is obligated to monitor the rating over the life of the debt
instrument.
Symbol
(Rating category).

Description (with regard to the

likelihood of meeting the debt
obligations on time)

AAA

Highest Safety

AA

High Safety

Adequate Safety

BBB

Moderate Safety

BB

Inadequate Safety

High Risk

Substantial Risk

Default

ICRA : ICRA was promoted by IFCI in 1991. The factors that ICRA takes into
consideration for rating depend on the nature of borrowing entity. The inherent
protective factors, marketing strategies, competitive edge, competence and
effectiveness of management, human resource development policies and practices,
hedging of risks, trends in cash flows and potential liquidity, financial flexibility,
asset quality and past record of servicing of debt as well as government policies
affecting the industry are examined.
Symbol
(Rating category).
LAAA
LAA
LA
LBBB
LBB

Description (with regard to the likelihood of

meeting the debt obligations on time)
highest-credit-quality & lowest credit risk.
high-credit-quality & low credit risk.
adequate-credit-quality & average credit risk.
moderate-credit-quality & higher than average credit
risk.
inadequate-credit-quality & high credit risk.

LB

risk-prone-credit-quality & very high credit risk.

LC

poor-credit-quality & limited prospect of recovery.

LD

lowest-credit-quality & low prospect of recovery.

CARE : CARE is a credit rating and information services company promoted by

IDBI jointly with investment institutions, banks and finance companies. The company
commenced its operations in October 1993.In January 1994, CARE commenced
publication of CAREVIEW, a quarterly journal of CARE ratings. In addition to the
rationale of all accepted ratings, CAREVIEW often carries special features of interest
to issuers of debt instruments, investors and other market players.
Symbol
(Rating category).
CARE AAA
CARE AA

Description (with regard to the likelihood of

meeting the debt obligations on time)
highest-credit-quality & lowest credit risk.
high-credit-quality & low credit risk.

CARE A

adequate-credit-quality & average credit risk.

CARE BBB

moderate-credit-quality & moderate credit risk.

CARE BB

moderate credit risk.

CARE B

high credit risk.

CARE C

Very high credit risk.

CARE D

Default or expected to be default.

Internationally acclaimed credit rating agencies such as Moody's, Standard and

Poor's , Duff and Fitch have been offering rating services to bond issuers over a
very long time. The bond issuers pay the rating agency to evaluate the quality of the
bond issue in order to increase the information flow to investors and hopefully
increase the demand for their bonds. The rating agency determines the appropriate
bond rating by assessing various factors.
Rating Category of Credit Agency Firms
Moody's Explanation
Aaa
Best quality
Aa
High quality
A
Higher-medium grade
Baa
Medium grade
Ba
Possess speculative elements
B
Generally lack characteristics of desirable investment
Caa
Poor standing; may be in default
Ca
Speculative in a high degree; often in default
C
Lowest grade

Standard & Poor's Explanation

AAA
Highest grade
AA
High grade
A
Upper medium grade
BBB
Medium grade
BB
Lower medium grade
B
Speculative
CCC-CC
Outright speculation
C
Reserved for income bonds
DDD-DD
In default, with rating indicating relative salvage value

Value of a bond
The value of a debt security today is the present value of the promised future cash
flows- the interest and the maturity value. Therefore, the present value of a debt is
the sum of the present value of the interest payments and the present value of the
maturity value.
B0 = I1/ (1+kd) 1+ I2/ (1+kd) 2+ I3/ (1+kd) 3+.. I1+Bn/ (1+kd) n
Where,
B0 =Present value of security
Bn =Maturity value of security
I = Interest payment
kd=Yield
Relation between the coupan rate, Price of the bond and the yield
If coupan rate > Yield, the security is worth more than its face valueIt sells at
premium
If coupan rate < Yield, the security is worth less than its face valueIt sells at
discount
If coupan rate = Yield, the security is valued at face value.

Bonds Yields
The yield of a bond is, the return on bond.The yield is expressed as an annual
percentage of the face value. However, yield is a little more complicated than the
coupan rate. There are several different measures of yield:
Nominal yield: It is equal to coupon rate; that is the return on the bond without
accounting for any outside factors. If you purchase a bond at par value and hold to
maturity, this will be the annual return you receive on the bond.
Current yeild: It is a measure of the return on the bond in relation to the current
price.
Yield to call: The rate of return that an investor would earn if he bought a callable
bond at its current market and held it until the call date given that th bond was called
on the call date.
Yield to Maturity

Yield To Maturity
The rate of return that an investor would earn if he bought the bond at its current
market price and held it until maturity, is called as YTM Alternatively,it represents the
discount rate which equates the discounted value of a bondss future cash flows to its
current market price. YTM is the overall return on the bond if it is held to maturity. It
reflects all the interest payment that are available through maturity and the principal
that will be repaid,and assumes that all coupan payments will be reinvested at the
current yield on the bond. This is the most valuable measure of yield because it
reflects the total income that you can receive.
YTM= [I+ (M-P)/N]/ [ (M+P)/2]
Where,
I=Annual Interest Payment
M=Maturity Value
P=Purchase price or current price of bond
N= Maturity period

Duration Of Bond
The term duration is a measurement of how long in years it takes for the price of a
bond to be repaid by its internal cash flows. Since a zero coupon bond doesnt pay
any intermediate cash flows and the entire money is available only on maturity,
duration of a zero coupon bond is equal to maturity period. On the same lines since
coupon bonds, pays coupons, we get our price much earlier to maturity period.
Therefore, duration of a coupon bond will always be less than maturity period.
Macaulay Duration
The formula usually used to calculate a bond's basic duration is the Macaulay
duration, which was created by Frederick Macaulay in 1938, although it was not
commonly used until the 1970s. Macaulay duration is calculated by adding the
results of multiplying the present value of each cash flow by the time it is received
and dividing by the total price of the security. The formula for Macaulay duration is as
follows:

n = number of cash flows

M = maturity (par) value
C = cash flow

i = required yield
t = time to maturity
P = bond purchase price

Steps for calculation:

Determine the bond cash flows till maturity.
Determine the PV factor using YTM.
Multiply the PV Factor into cash flows to find present value of cash flows.
Add the PV of all cash flows to determine the market value of the bond.
Divide each years cash flows by the market value of bond.
Multiply this factor by the corresponding years i.e. 1 figure by 1, year 2 figure by 2 etc.
The sum of all final values is the duration.

Modified Duration
Modified duration is a modification of the Macaulay duration to estimate interest rate
risk, calculating the change in a bonds price to a change in its yield to maturity. This
is the approximation of the percentage change in the price of the bond to the
percentage change in yield. For bonds without any embedded features, bond price
and interest rate move in opposite directions, so there is an inverse relationship
between modified duration and an approximate 1% change in yield. Because the
modified duration formula shows how a bond's duration changes in relation to interest
rate movements, the formula is appropriate for investors wishing to measure the
volatility of a particular bond. Modified duration is calculated by the following formula:

OR

Duration Application: Calculating bond value change

Duration measures interest rate risk , i.e., changes in present value of securities
when interest rates change. Knowing duration we can calculate the price sensitivity
as follows:
Percent change in bond value = DM * change in yield
Where,
DM=Modified duration
If yield rates rose from 10% to 10.5%, a 0.5% increase in rates, Macaulays formula
would predict a percent change in value as:
Percent change in bond value = DM * numerical change in stated yield.4
= 2.6439 * (+ 0.5)
= 1.3220%
The price change calculated by MDuration would be $898.49 * 1.322% = $11.88
The new bond price would be approximately $898.49 $11.88 = $886.61. We can
confirm the percent change and new price by entering these data into a
spreadsheet: The change takes place in the PV Factor as a result of the change in
market yield.

Bond Convexity: Convexity measures the rate of change in modified duration as yield
change. Convexity refers to the shape of the price-yield relationship and can be used
to refine the modified duration approximation of the sensitivity of prices to interest
rate changes. Bond Convexity is defined formally as the degree to which the
duration changes when the yield to maturity changes. It can be used to account
for the inaccuracies of the Modified Duration approximation. On top of that, if we
assume two bonds will provide the same duration and yield then the bond with the
greater convexity will be less affected by interest rate change.

Application of Convexity
The convexity improves the duration approximation for bond price changes. In other
words, knowing convexity, we can find a better approximations of bond price change for
every change in yield, than what we can find using duration. It is a measure of the
relationship between bond prices and bond yields that demonstrates how the duration
of a bond changes as the interest rate changes. Convexity is used as a riskmanagement tool, and helps to measure and manage the amount of market risk to
which a portfolio of bonds is exposed.
The formula is:

1
2
%P=ModD i+ Convexity( i )
2

1. A bond of Rs. 1000 bearing a coupon rate of 12% is redeemable at par in 10 year.
Find out the value of the bond if:
(a)Required rate of return is 12%
(b)Required rate of return is 14% and the maturity period is 8 yrs
(c)Required rate of return is 12% and redeemable at Rs.1050 after 10 years.
2. A bond of Rs.1000 bearing a coupon rate of 12% p.a. payable half-yearly is
redeemable after 4 years at par. Find out the value of the bond given that required
rate of return is 14%.
3. A bond of Rs.10000 bearing coupon rate 12% and redeemable in 8 yrs at par is
being traded at Rs. 10600. Find out YTM of the bond.
4. Bond A has face value of Rs.100, Coupon rate 15%p.a., maturity period 6 years,
maturity value Rs.100 and current market price 89.5 and YTM is 18%.Calculate
duration of bonds.
5. A 5 year bond with 8% coupon rate and maturity value of Rs.1000 is currently
selling at Rs.925. Find YTM.

6. The following data is available for a XYZ Bond, face value Rs.1000, Coupon rate
16%p.a., life of bond 6 yrs, maturity value Rs.1000,current market price 964.5.
You are required to calculate:
1) YTM
2)Duration of bond 3)Volatility of bond
7.Two bonds A & B have a par value of Rs.10000 and YTM of 9%.Both mature after 4
years. A pays annual coupon of 10% and B pays annual coupon of7.5%. Calculate
duration of both bonds A & B.
8. The following data is available for a bond:
Face Value

Rs.1ooo

Coupon

16%p.a.

Years to maturity

6 Years

Redemption Value

Rs.1000

Current market price

Rs. 950

Calculate YTM, Duration & volatility of this bond.

9. A bond can be acquired with a 4 year maturity. The bond has a coupon of 12%
payable annually and is priced in the market at Rs.100. What is the duration of the
bond? What would be the percentage change in price if interest rates rose to 13%.

10. Bonds A & B carry coupon rates of 4% & 12% respectively. Both bonds have 10
years to maturity and pays interest annually. If the discount rate (YTM) on both bonds
rises from 8% to 10%, Calculate the expected % change in the bonds prices.
11. The following data are available for a bond:
Face Value

Rs. 1000

Coupon Rate

16%

Maturity Period

6 Yrs

Redemption Value

Rs.1000

YTM

17%

What is the current market price, duration and volatility of this bond? Calculate the
expected market price, if we witness an increase in required yield by 75 basis
points.

12. Calculate convexity given the following with respect to a coupon bond.
Coupon rate= 6%, Term= 5 years, yield to maturity= 7 %(3.5% semi annually) and
Price=Rs. 958.42
13. Determine the convexity of an 8% coupon bond with two years to maturity an a
zero coupon bond with 20 years to maturity. The yield-to-maturity on these bond is
10% p.a. Find out the price change of the zero coupon bond,and 8% coupon bond, if
the yield changes to 11% using:
a)Using duration formula
b)Using Convexity
c)Actual bond price formula
14. Calculate the price of a zero-coupon bond that is maturing in five years, has a par
value of Rs.1,000 and a required yield of 6%.
15. Calculate the yield of a zero-coupon bond that is maturing in ten years, has a par
value of Rs.1,000 and purchase price is Rs. 540.