final bond market

8/8/2019 Final Bond Market

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INDEX

Sr. No. Topic Page

No.

1 Introduction 2-5

2 Types of Bonds 6-10

3 Term Structure 11-18

4 Coupon Rate Determinant 19-22

5 Interest Rate Risk

Management

23-25

6 Risk Associated with Bonds 26-28

7 Difference between Bond

Market & Stock Market

29-31

8 Bonds on NYSE 32-36

9 Bibliography 37

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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 itsyield; 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 peryear. 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 maturityare known aszero-coupon bonds.

It is important to be aware of the fundamental relationship

between a bonds yield and its maturity (the predeterminedtime for payback). Longer maturities generally translate to

higher yields, because of the increased potential that, over

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

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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 primarymarkets. 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 thebond 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 thecoupon.

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Features of Bonds

The most important features of a bond are:

Nominal, Principal Or Face Amount: The amount on whichthe 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;

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

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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 contractsbetween 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 morerisky 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.

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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 torepay 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 bondsearly, 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 thatit 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

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

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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 tothe 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,

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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.

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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 financialinstitution 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 bondsissued by banks, and asset-backed securities. The latter are

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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 theUK 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 orassets. 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 theregistered 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.

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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 bonddistinguished 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.

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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-incomesecurities 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 theeconomy 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

market because short-term instruments generally hold less

risk than long-term instruments; the farther into the future

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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

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 long-

term interest rates decline, a flat curve can sometimes lead to

an inverted curve.

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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.

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, whichcauses 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 tomaturity was calculated, we assumed that the coupons were

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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

fixed-income 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.

The spot-rate curve is created by plotting the yields of zero-coupon 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 zero-

coupon 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.

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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

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 Treasurysecurities widens. This is because investors must be offered

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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

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 termstructure of interest rates and explain the shape of theyield curve.

1. Pure Expectations Theory:

The expectations hypothesis (also known as the unbiasedexpectations theory, or pure expectations theory)imagines a yield curve that reflects what bond investors expectto earn on successive investments in short-term bonds duringthe term to maturity of the long-term bond.

It suggests that the term structure of interest rates isbased on investor expectations about future rates ofinflation and corresponding future interest rates,

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assuming that the real interest rate is the same for allmaturities.

According to the theory, forward rates exclusivelyrepresent expected future rates. Thus, the entire term

structure at a given time reflects the market's currentexpectations of the family of future short-term rates.

Under this view, a rising term structure must indicate thatincreasing rates of inflation are expected, and the marketexpects short-term rates to rise throughout the relevantfuture. Similarly, a flat term structure reflects anexpectation that future short-term rates will remainrelatively constant, while a falling term structure mustreflect an expectation of decreasing rates of inflation and

that future short-term rates will decline steadily.

This theory suffers from one serious shortcoming: it saysnothing about the risks inherent in investing in bonds and likeinstruments. If forward rates were perfect predictors of futureinterest rates, then the future prices of bonds would be knownwith certainty!

2. Liquidity Preference Hypothesis

According to the liquidity preference hypothesis (alsoknown as the maturity premium theory), long-term bondsare 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 pricevolatility when interest rates change.

All else equal, rational investors will prefer the less risky, short-term bonds. Therefore, long-term bonds should always providea maturity premium to compensate for the liquidity risk. Basedon this theory, an upward sloping yield curve may be caused byone of the following two reasons:

1. Future interest rates will rise, or

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2. Future interest rates will be unchanged or fall, but thematurity premium will increase fast enough with maturityso as to cause the yield curve to slope upward.

Flat or downward sloping yield curves are mainly caused bydeclining future short-term interest rates.

3. Market Segmentation Theory:

Both of the above theories assume that an investor holdingbonds of one maturity can switch to holding bonds of anothermaturity. The market segmentation theory contends that shapeof the yield curve is determined by supply of and demand for

securities within each maturity sector. It believes that the yieldcurve mirrors the investment policies of institutional investorswho have different maturity preferences.

Banks need liquidity and prefer to invest in short-termbonds, while corporations with seasonal fund needs preferto issue short-term bonds.

Life insurance companies prefer to invest in long-termbonds to match their long-term liabilities, while real estate

companies prefer to issue long-term bonds due to theirlong project cycles.

The bond market is segmented based on the maturitypreferences of investors and issuers. Within each marketsegment, the prevailing yields are determined by the supplyand demand for the bonds. An upward sloping yield curveindicates that:

Demand outstrips supply for short-term bonds, causinglow 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 long-term bonds are in equilibrium so interest rates are the same forall maturities. You should be able to draw similar conclusionsfor other types of yield curves.

The Preferred Habitat Theory:

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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

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 higherreturn.

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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 demandfor bonds rises, or shifts right. So when an expandingeconomy increases both income and wealth, we expectbond demand to increase too.

A change in expected interest rates/returns. Forbonds with more than a year to maturity, rising interestrates in the future will decrease the value of the bond(and hence the expected return). At each and every price,fewer bonds will be demanded. Bond demand will fall, or

shift left when expected future interest rates fall. The sizeof the decrease will be larger for longer term bonds.

A change in expected inflation. If investors expect theinflation rate to rise, then they expect the real return ontheir 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 givenprice or expected return, if bonds become riskier thanother assets, people will switch to less risky assets. An

increase in the relative risk of bonds with decrease bonddemand.

A change in the relative liquidity of bonds. If itbecomes harder to resell bonds in the bond marketrelative to other assets, people will switch to assets thatare easier to resell. A decrease in the relative liquidity ofbonds will decrease bond demand.

When of Supply of bond is high

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A change in business conditions. Firms issue bonds tofinance the purchase of capital equipment and theexpansion of production. This makes sense only if thisexpansion is expected to be profitable. As economic

conditions become more favorable, expected profitabilityrises and bond supply will increase or shift right. Also taxincentives for borrowing can also be considered abusiness condition.

A change in expected inflation. While rising inflationdecreases the real return for those who buy bonds, itdecreases the real cost of borrowing for those who issuebonds: 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.

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 andpaying 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.

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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

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 therisk free rate. As the risk free rate increases firm value

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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.

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

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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 inthe slope and shape of the yield curve.

3. Basis Risk (spread risk): Arises when assets andliabilities are priced off different yield curves and thespread between these curves shifts. When this yield curvespreads change, income and market values may be

negatively affected. Such situations arise when an assetthat is re-priced regularly (say) based on the inflationindex is funded by a liability that is re-priced based (say)on the central bank accommodation rate

4. Optionality: Options may be embedded within otherwisestandard instruments. The latter may include varioustypes of bonds or notes with caller put provisions, non-maturity deposit instruments that give the depositor has

the right to withdraw their money, or loans that borrowersmay pre pay without penalty.

Framework for IRM

Broad principles to the foundation for interest rate riskmanagement.

Board of Directors to approve strategies and policies forinterest 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

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managed. Appropriate policies and procedures are in

place to control these risks. Resources are available for

evaluating and controlling this risk.

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 a

breakdown of all underlying assumptions. The result there

from must be factored into the policies and the limits

determined.

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Banks must have adequate information systems for

measuring, monitoring, controlling and reporting interest

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.

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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????

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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

Purchasing power risk arises because of the variation in

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

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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.

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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.

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

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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 acompany. 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 thisreturn 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

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

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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.

Short term Treasury yields havent moved from therecessionary 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).

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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 shouldstudy 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

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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-yearTreasury is considered safe. And there's another benefit to

Treasury: The income you earn is exempt from state and local

taxes.

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 governmentwill 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 tax-

free.)

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

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taxable bonds. But depending on your tax rate, your net return

may be higher than it would be on a regular bond.

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 fixed-

income 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

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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

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 high-

yield, 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

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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 full-

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 (FarmerMac)

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

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A municipal debt on which the payment of interest and

principal depends on revenues from the particular asset that

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 uponthe performance of an equity market index, such as theStandard & Poors 500 Composite Price Index of U.S. stocks,measured from a predetermined level.

These notes are issued so that a conservative investor mayparticipate in equity market returns while at the same timeensuring that principal will be repaid at maturity regardless ofthe equity market's performance. This feature eliminates the

risk of losing principal that is inherent in traditional stock andmutual fund investments.

These notes usually have a maturity of anywhere between two-and-eight years. Typical notes allow an investor the choice of(i) holding the note to maturity and receiving any variablereturn at maturity, (ii) selling the note in the secondary marketprior to maturity, or (iii) electing to receive early payment ofvariable return prior to maturity based on any index

performance up to the time of election and receiving theprincipal amount at maturity.

Sovereign Bonds

A sovereign bond is a bondissued by a national government.The term usually refers to bonds issued in foreign currencies,while bonds issued by national governments in the country'sown currency are referred to as government bonds.The total

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

BIBLIOGRAPHY

i. www.investopedia.com

ii. www.wikipedia.com

iii. www.yahoofinance.com

iv. www.google.com

v. www.nyse.com
http://www.investopedia.com/http://www.wikipedia.com/http://www.yahoofinance.com/http://www.google.com/http://www.nyse.com/http://www.investopedia.com/http://www.wikipedia.com/http://www.yahoofinance.com/http://www.google.com/http://www.nyse.com/

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