FIXED INVESTMENT MANAGEMENT

FINANCIAL MANAGEMENT 1
 Fixed Investment Management

Case Background
The board of trustees of the endowment of the Amboli Golf Club (AGC) included
several professionals who gathered four times each year during second week of January, April,
July and October to evaluate the performance of their fund. The trustees of the AGC, every
year, sought advice from the Fixed Investment Management (FIM), Mumbai over which bonds
to buy. Typically, AGC would provide FIM with certain medium term goals and FIM would
get back to AGC with recommendations as to which bonds would meet those goals. FIM
managed a fixed income portfolio of the Rs. 50 Crores for AGC.

The trustees of AGC wished to preserve the principal, hence invested in relatively safer bonds.
While the trustees were all professionals, none of them was an expert on the financial matters,
and they evaluated the bonds based on the previous performance. Post the cut in GOI rates to
6.549% from 7.783% by the RBI, the trustees were looking for a safe bond which would also
provide them with high yield.
Fixed Income Management, post receiving the investment goals from the AGC, held meetings
to zero in on one bond which they would put forward to the trustees as their recommendation.
In January 2017, after receiving the direction of finding a safe and high yield bond, Robert
organised a meeting with its analysts to come to a final recommendation. Four bonds were
proposed by the team of analysts which were GOI Treasury Bond at 8.08%, State Bank of India
Bond at 10.1%, DS Kulkarni Developers Limited Bond at 12.75% and Andhra Pradesh State
Financial Corporation Bond at 9.15%. The analysts used the ratings of these bonds are provided
by Crisil to assess the risk attached. Now as part of the meeting, the coupon rate and the last
traded price for each of the bonds was available, however, yield was yet to be determined. The
bond which would provide the best combination of yield and risk would become the final
recommendation of FIM to the trustees of AGC.
Financial Aspects
Following are the key financial aspects pertaining to the case:

1.) Interest Accrued

For the purpose of assessing the bonds, the analysts have overlooked the interest
accrued on each of the bonds since the last release of coupon amount.
The interest is accrued on each instalment of the coupon between one payment date to
another. While determining the net value of a bond it is important to adjust the cash
flows for the interest accrued if the bond purchase date is not same as the coupon
payment date. For instance, if the number of days between coupon payment dates is
and the first period is not exactly a full coupon period then the coupon size must be
calculated as DCF×c, where DCF is calculated as the day count fraction between the
dated date and the first coupon date using the correct day count convention.

2.) Duration and Volatility of Bonds

Financial managers and investors often monitor duration of a bond so as to assess how
the bond prices change with the interest rate changes unlike the analysts at FIM. The
duration is the weighted average of the times to each of the cash payments. The times
are the future years extending to the final maturity date which we call T. The weight
for each year is the present value of the cash flow divided by the total present value of
the bond.
Duration = Σ 1 x PV (C1)/PV
Where the summation runs over the period of the bond.

The duration of the bond is also used to determine the volatility of the bond which is
given as:
Volatility (%) = Duration / (1 + yield)
The value basically denotes the change in the price of the bond for 1% change in the
interest rates.
3.) Safe Bonds with high yields
The analysts at FIM were looking for bonds which would provide a high yield but at
the same time would be low on risk. This apparently was very difficult to be achieved
at the same time because so as to achieve a high yield the bond by nature should be
volatile enough to register a surge in its price. Bonds which floated closer to the par
value by default become the ones with maximum yield for the lower variability.
4.) Risk Aversion at AGC
Being in a fixed income market, the trustees wished to preserve their principal at all
costs, thereby having high aversion to risk. This limited the scope for the analysts at
FIM as the bonds with highest of the yields always have a higher risk associated.
Analysis and Interpretations
As part of analysing the four bonds, we are required to find the bond which would
provide the most favourable combination of risk and yield. So as to determine the price of a
bond we discount the cash flows associated with a bond at interest rate and the cash flow being
the fixed amount calculated using the coupon rate of the bond.
Therefore for a coupon rate of of C and interest rate of r, we get the price of a bond as:

P = C [Σ 1/ (1+r) ^t] + Bond Face Value / (1+r) ^t

Where t is the time period of maturity of the bond,
C is the annual/semi-annual cash flow that the bond returns,
R is the interest rate at which we discount.

Now once we know the figure at which the bond is priced and we have the annual cash flows,
we determine the rate r which forms the yield to maturity for the bond. Because of multiple
cash flows involved, it almost impossible to determine the yield of a bond by solving the
mathematical equation that would unfold. We use the method of trial and error to estimate the
yield to maturity associated with the given cash flow. While doing this trial and error, we keep
the following points in consideration:

a.) As the price of the bond falls, the rate must have increased because of the inverse
relation the two values have.
b.) The price when higher than the face value is said to be at premium, if lower is called as
selling at discount.
c.) Using the first point, we can say when the bond is selling at premium, we need to
increase the rate so as to get closer to the price level.

We will employ the above understanding to the four bonds which are being discussed as the
meeting being held at FIM, so as to determine the yield they were offering.

GOI Treasury Bond

The GOI Treasury Bond was due for maturity in almost five years of time at 2 nd of
August, 2022. The coupon rate of the bond was set at 8.08% while the coupon payment, as in
the cash flow, would occur annually. The bond is considered to be one of the safest ones with
a rating of AAA by Cirisil. The last traced price for the bond was 105.55 percent.

Now using the inputs above, we perform calculate the price of the bond at various yield rates
so as to converge on the last traded price.
GOI Treasury Bond Cash Flow for different yields
Index Coupon Amount 8.080% 6.918%
1 8.08 7.476 7.56
2 8.08 6.917 7.07
3 8.08 6.400 6.61
4 8.08 5.921 6.18
5 8.08 5.479 5.78
6 8.08 5.069 5.41
 6 100.00 62.738 66.94
Total 100.00 105.55

State Bank of India

The SBI’s bond had a maturity period of 5 years, as was due for 12th September 2022.
The bond had coupon rate of 10.1% with a rating of AAA. The payments were to be given out
yearly. At the time of comparison, the bond was trading at 101.48%.
We use the above figures to try and find out the expected yield for the bond.
State Bank of India Cash Flow at varying yields
Year Coupon Amount 10.100% 9.762%
1 10.10 9.173 9.202
2 10.10 8.332 8.383
3 10.10 7.568 7.638
4 10.10 6.873 6.958
5 10.10 6.243 6.340
6 10.10 5.670 5.776
6 100.00 56.140 57.186
Total 100.00 101.48

DS Kulkarni Developers Limited

DS Kulkarni Developers had their bond priced at a discount. Its last trading price was
73.5% with a coupon rate of 12.75%. It had a rating of BBB+ hence a little riskier than the first
two bonds, however, the coupon rate was on a higher side. The bond was to expire on 4th of
August 2022. The payments were to be made quarterly which meant there were to be 20
payments made between now and the time the bond expired.

As the bond is trading at a discount, the yield rate must be lower higher than the coupon rate.
We plug in the values for the yield going upwards from the coupon rate to try and converge at
the trading price. Following this, we obtain that the yield to maturity for this particular bond is
17.605% which apparently is much higher than the other two bonds discussed so far, however,
it comes with more risk attached.
The bond prices for the various yield rates are as follows:
DS Kulkarni Cash Flow at Different Yields
Period Coupon Amount 12.750% 17.605%
1 12.75 11.308 10.841
2 12.75 10.029 9.218
3 12.75 8.895 7.838
4 12.75 7.889 6.665
5 12.75 6.997 5.667
6 12.75 6.206 4.819
7 12.75 5.504 4.098
8 12.75 4.882 3.484
9 12.75 4.330 2.963
10 12.75 3.840 2.519
11 12.75 3.406 2.142
 12 12.75 3.021 1.821
13 12.75 2.679 1.549
14 12.75 2.376 1.317
15 12.75 2.107 1.120
16 12.75 1.869 0.952
17 12.75 1.658 0.810
18 12.75 1.470 0.688
19 12.75 1.304 0.585
20 12.75 1.157 0.498
20 100.00 9.071 3.904
Total 100.00 73.50
Andhra Pradesh State Financial Corporation
The bond being offered by the Andhra Pradesh State Financial Corporation was trading
at a discounted price of 49.15%. The bond was to expire on 20th March 2023 with a coupon
rate of 9.15%. The payments were to be made semi-annually which would mean a total of 11
payments were to be made. It came with a rating of BB+ hence the highest risk attached among
the four bonds proposed.

We use the above figures to determine the yield to maturity of the given bonds. As before, we
move upwards from the coupon rate as the bond is trading at a discount, hence the expected
yield to maturity must be higher than the coupon rate.
Below are the cash flows associated with varying yield rates:
AP State Fin
Corp Cash Flow for different yields
Period Coupon Amount 9.150% 21.565%
1 9.15 8.383 7.527
2 9.15 7.680 6.192
3 9.15 7.036 5.093
4 9.15 6.447 4.190
5 9.15 5.906 3.447
6 9.15 5.411 2.835
7 9.15 4.957 2.332
8 9.15 4.542 1.918
9 9.15 4.161 1.578
10 9.15 3.812 1.298
11 9.15 3.493 1.068
11 100.00 38.171 11.671
Total 100.00 49.15

Apparently the bond prices converge at the rate of 21.565%. Therefore the expected yield to
maturity for the given bond is 21.565%.The Andhra Pradesh State Financial Corporation has
the highest yield rate among all the four bonds, however, it comes with the highest risk as well.
Recommendation
For the four bonds proposed by the team of analyst at FIM, we can summarise the
results as follows:

GOI Treasury State Bank of DS Kulkarni AP State Financial

Bond India Bond Corporation
Maturity 5 5 5 5.5
Coupon 8.08% 10.10% 12.75% 9.15%
Coupon Payment Yearly Yearly Quarterly Semi Annual
Credit Rating AAA AAA BBB+ BB+
Last Traded Price 105.55 101.48 73.5 49.15
Yield 6.918% 9.762% 17.605% 21.565%

Out of the four bonds, the one by State Bank of India seems to be the best fit in terms
of yield of maturity and risk attached. DS Kulkarni could be termed as the second best choice
for the high yield attached although is unlikely to be accepted by the trustees of AGC.