Bonds: Types, Trading & Settlement

Debt Instruments Features

Face Value/Par Value Maturity Interest (Coupon) - Annual/Semi-annual/Quarterly - Fixed/Floating - Ex-interest/Cum-interest(Accrued) - Zero Coupon Bond

Debt market instruments

Debentures: Bond: Commercial Paper

Certificate of Deposit

A long term promissory note for raising loan capital Bond is an alternate form of debenture being issued mostly by public sector companies in India Unsecured promissory note used by firms to raise short term capital. They are redeemable at par to the holder at maturity. Negotiable term deposit certificates issued by banks/ financial institutions at discount to face value

PARTICIPANTS AND PRODUCTS IN THE DEBT MARKET

Debt Security Connotation

Coupon

11.50% GOI 2011

Year of Maturity

Security

How does investment in Debt security appreciate?

Income from Interest This is the coupon rate on the security/bond Mark to Market gain /loss Security/bond prices rise when interest rates decline Security/bond prices decline when interest rates rise

Income from interest

Face value Coupon Earning for Year 1 Earning for each day

Rs. 100/8.5% Semi Annual Rs. 8.50 Rs.8.50/365 = 0.0233

Yield

Current Yield Yield to Maturity (YTM) Zero Coupon Yield Curve (ZCYC)

Current Yield

A bonds yield is the interest the bond pays divided by its price. If you buy a 10-year $1,000 bond paying 6% and hold it until it matures, youll earn $60 a year for ten years an annual yield of 6%, or the same as the interest rate. If you buy a bond in the secondary market, after the date of issue, the bonds current yield differs from its interest rate. Bond prices arent fixed at their par value of $1,000, and generally sell for more or less than that amount. The actual price is determined by supply and demand, or what investors are willing to pay. And the current yield is determined by the price at the time of purchase. If the price is more than par, or a premium, the current yield is less than the bonds interest rate. For example, if you spend $1,200 for a $1,000 bond paying 6% interest, the yield would be 5%. And if the price is less than par, or a discount, the current yield is more than the stated interest. In this case, if you pay $920 for a 6% bond, the yield is 6.52%.

Yield-to-Maturity (YTM)

The most accurate measure of the long-term yield on a bond investment is its yield to maturity (YTM). YTM is calculated using the bonds interest rate, the current price, the par value and the years to maturity.

Yield-to-Maturity (YTM)

The price- yield relationship is P = C1 + C2 +. Cn +A (1+y)1 (1+y)2 (1+y)n P = Price of the bond N =Maturity in years A= Maturity value The value of y that satisfies the above equation is called the YTM (Yield to maturity)

Mark to Market Gain / Loss

Interest Rate Decline

Bond Prices Rise

NEW BUYING /TRADING PRICE

OLD BOND 105

NEW BOND 100

Interest Rate Rise

AT MATURITY OF FIVE YEARS PRINCIPAL INTEREST EARNED TOTAL GAIN

100 42.5 37.5

100 37.5 37.5

Positive impact on bond markets

1.

2.
3. 4. 5. 6.

Interest rate increases Volatility in stock markets Tax increases International conflicts Controlled inflation Tight money supply

Negative impact on bond markets

1.

2.
3. 4.

Interest rate cuts Tax cuts High inflation Loose money supply

Types of Bonds

1. 2. 3.

Most bonds are issued by one of three groups Central/Federal Government State and Local Governments Corporations including Banks and Institutions

Role of Central Bank

The Federal Reserve System, popularly known as the Fed, is the central bank of the U.S. Most important role is regulating the money supply i.e. currency in circulation, the reserves held by banks, and money being deposited and re-deposited in bank accounts. More money supply makes it easier and cheaper to borrow. And with less money circulating, it becomes more expensive borrowing. Fed influences the money supply through its open market operations (buying or selling securities) thereby influencing the health of the economy. If it believes the pace of growth is too rapid, it reduces, or tightens, the money supply. Conversely, if growth slows or a recession seems possible, the Fed increases, or loosens, the money supply.

U.S. Government Bonds

1. 2. 3.

The bonds issued by Govt. are called Treasuries: 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 Treasuries are widely regarded as the safest bond investments, because they are backed by the U.S. government. A 30-year Treasury has more upside than a 90-day Tbill or a five-year note. But it also carries the potential for considerably more downside in terms of inflation and credit risk

GOVT BONDS

Interest payments are exempt from local and state taxes (however, not from Federal income taxes). Cannot be redeemed before maturity and do not have call provisions. Can be bought through brokers, or directly from the federal government, which holds regular auctions that individual investors can participate in. Services of a broker needed to sell the bonds in the secondary markets

TREASURY BILLS

Treasury Bills are issued in three maturities: 91 days, 182 days & 364 days Bills with 91-day and 182-day maturities are auctioned by the Treasury each Monday. 364-day Bills are auctioned every four weeks on Thursday, 13 times a year. Interest rate of T-Bills is determined at each auction, depending on the bids. T-Bills do not make interest payments, they are issued at a discount to face value.

TREASURY NOTES & BONDS

Treasury Notes issued in 2, 3, 5 & 10 year maturities. 2 & 5 year Notes are auctioned each month 3 year Notes are issued quarterly 10 year Notes are auctioned six times a year. All Notes pay interest twice a year, and expire at par value. Treasury Bonds are usually issued in thirtyyear maturities, and pay interest twice a year

TREASURIES

Large investors, institutional investors, banks, use the Commercial Book-Entry System. Individuals can use Treasury Direct to make purchases of Treasury securities at auction. No brokerage fees or other transaction charges when buying through Treasury Direct.

U.S. Treasury STRIPS

Separate Trading of Registered Interest and Principal of Securities Type of Treasury security known as zerocoupon bonds. Investors purchase STRIPS at a substantial discount and redeem them upon maturity for their par value. Treasury STRIPS are offered in a wide range of maturities in minimum denominations of $1,000.

Treasury Inflation Protected Securities (TIPS)

Principal and interest payments are protected from inflation Offer investors a government guarantee that the real purchasing power of their principal will keep pace with the rate of inflation. Available in a variety of maturities. TIPS pay interest semi-annually and are offered in minimum denominations of $1,000.

AGENCY BONDS 101

Other government agencies (usually at the federal level) issue bonds to support projects relevant to public policy, such as farming, small business, or loans to first-time home buyers. High regard by investors as issued by a government agency. Institutions and individuals can invest in this segment of the debt securities market.

FEDERAL AGENCIES

Federal National Mortgage Association (Fannie Mae) Federal Home Loan Mortgage Corporation (Freddie Mac) Farm Credit System Financial Assistance Corporation, Federal Agricultural Mortgage Corporation (Farmer Mac) Federal Home Loan Banks (Home Loan) Student Loan Marketing Association (Sallie Mae), College Construction Loan Insurance Association (Connie Lee), Govt. National Mortgage Association (Ginnie Mae)

Municipal Bonds (Munis)

A step up on the risk scale from Treasuries, but tax advantage Munis are triple-tax free According to the U.S. Constitution, the federal government can't tax interest on state or local bonds (and vice versa). A local government will often exempt its own citizens from taxes on its bonds, so that many munis are safe from city, state and federal taxes. Triple tax-free munis generally offer a lower coupon rate than equivalent taxable bonds.

Corporate Bonds

1. 2. 3.

Generally the riskiest fixed-income securities All companies more susceptible than Govt (Pan Am, LTV Steel and the Chrysler bankruptcies of 1979) Corporates come in several maturities: Short term: one to five years Intermediate term: five to 15 years Long term: longer than 15 years Credit quality of companies and governments is monitored by two major debt-rating agencies: Standard & Poor's and Moody's.

Zero-Coupon Bonds (ZCBs/Zeros)

Fixed-income securities that don't make interest payments each year. Bond sold at a deep discount to its face value and at maturity, the bondholder collects all of the compounded interest, plus the principal. Usually priced aggressively and are useful for investors who are looking for a set payout on a given date, instead of a stream of payments Zeros do have a tax drawback (unless held in a taxdeferred retirement account or an education IRA). Since interest is technically earned and compounded semiannually, holders are obliged to pay taxes each year on the interest as it accrues i.e. pay tax before getting the money.

Bond Offerings

Primary Market Offerings except: U.S. Treasury bills and notes are sold competitively in a Dutch auction. That means the bids offering to accept the lowest interest (which means they offer to pay the highest prices) are accepted first, and the auction continues at incrementally higher bids until the quota is filled. The final bid becomes the auction rate, and all lower bidders have their orders filled at that rate. Individual investors, who make noncompetitive offers, also get the auction rate.

Competitive Vs Non-Competitive Bids

By bidding noncompetitively, investor agrees to accept whatever rate or yield is determined at the auction. Investors who don't consider themselves expert securities traders usually bid noncompetitively. A competitive bid is one where you specify the rate or yield you will accept. US Govt. may reject a competitive bid, grant it in less than the amount requested, or grant it in the full.

Bond Quotations

Prices of corporate and municipal bonds are quoted in points and 8ths of a point, and each point is a unit of $10. For example, if a bonds price is quoted as 96 1/2, its selling at $965 (96.5 x 10 = 965). Prices of Treasury bills and notes are quoted in units of 100 and 32nds of 100 (rather than 8ths) to permit subtler price differences. If a T-bills price is 100 and 9/32 (sometimes abbreviated as 100:09). To get the actual price you convert the fraction to a decimal (9/32 = 9 x 0.3125 = 2.8125). So a bond quoted as 100 and 9/32 is selling for $102.81.

Secondary Market Trading

Most bond issues, including U.S. government bonds, are listed on NYSE and AMEX but have their chief market over-the-counter. Other U.S. government securities, as well as state and municipal bonds, are traded over-the-counter exclusively. Institutional investors such as MFs often trade OTC as they are given volume discounts. Regulation of the OTC market is carried out largely by the NASD.

Bond trading

OTC trading in the bond trading rooms of U.S. exchanges and brokerage firms. Bond brokers and dealers use electronic display terminals that give them the latest price information and handle the transactions by telephone. Typically, a buyer searches for a seller currently offering the best price for a particular issue and calls to negotiate the trade. Brokerage firms who make a market in particular bonds keep inventories on hand to sell to their own clients or to brokers from other firms who are trying to fill an order. Dealers working for the firm try to amass a supply of bonds at the lowest possible prices.

Global Clearing Agencies

1. 2.

Fixed Income Clearing Corporation (FICC), owned by US based Depository Trust & Clearing Corporation (DTCC) has 2 divisions: Govt. Securities Division Mortgage Backed Securities Division Euroclear. Also acts as the Central Securities Depository (CSD) for Dutch, French, Irish and UK securities. CDS Owned by major Canadian banks, and the members of the Toronto Stock Exchange and the Investment Dealers Association of Canada (IDA). Clearstream: Deutsche Bourse Group

Settlement

End-of-day net settlement of a participant's net settlement obligations resulting from trading activity. Collateralization controls and net debit caps employed to protect participants against the inability of one or more participants to pay for their settlement obligations.

Indian Scenario

G-secs and T-bills deemed to be listed automatically as and when they are issued. Other securities, issued publicly or placed privately, could be listed or admitted for trading, as per eligibility. T- Bills, G-Secs, Corporate and PSU debt securities available in demat form are eligible for Repo. Market capitalisation of the securities on the WDM segment has been increasing steadily.

Debt Markets: Features

Negotiated Dealing System Wholesale Debt Market of NSE Dematerialisation of Debt Instruments Clearing Corporation of India Limited

Monthly Trades On WDM-NSE

WDM Turnover (Rs.Bn)

Total Turnover

Average Daily Turnover

1600 1400 1200 1000 800 600 400 200 0 Apr-02 May- Jun-02 Jul-02 Aug02 02 Sep- Oct-02 Nov02 02 Dec- Jan-03 Feb-03 Mar-03 02

60 55 50 45 40 35 30 25 20

Business Growth of WDM Segment

EMERGING CONCEPTS
FIMMDA- NSE MIBID/MIBOR
1 Month MIBID 1 Month MIBOR
9 8.5 8 7.5 7 6.5 6 5.5 5 DATE 2-May-02 30-May- 26-Jun-02 24-Jul-02 23-Aug-02 24-Sep-02 26-Oct -02 27-Nov-02 28-Dec-02 24-Jan-03 22-Feb-03 25-Mar-03 02

3 Month MIBID 3 Month MIBOR

Emerging Concepts

Value At Risk Bond Index Interest Rate Derivatives Retailing in Govt. Securities

Settlement NSE (WDM Segment)

Trades are settled gross, i.e. on trade for trade basis directly between the constituents/ participants to the trade, not through Clearing House mechanism. Each transaction is settled individually and netting of transactions is not allowed. Settlement is on a rolling basis, i.e. there is no account period settlement. Each order has a unique settlement date specified upfront at the time of order entry and used as a matching parameter.

Settlement NSE (WDM Segment)

Settlement periods ranging from T+0 to a maximum of T+2 On settlement date, the Exchange provides data to the respective member regarding trades to be settled on that day with details like security, counter party and consideration. Participants through their Subsidiary General Ledger (SGL) account (a book entry settlement system) settle government securities including treasury bills with RBI or through exchange of physical certificates. Other instruments are settled through delivery of physical securities.

Settlement NSE (WDM Segment)

Where trade is settled through the SGL account, exchange of securities and funds is done on DVP basis. Where trade is settled through delivery of certificates, the consideration is paid through cheque/payorder The required settlement details, i.e. certificate no., SGL form no., Cheque no., constituent etc. are reported by the member/ participant to the Exchange. In case of Repo trades the settlement details of the forward leg is also reported.

Settlement NSE (WDM Segment)

NSE monitors the settlement of transactions through the reporting of settlement details by members and participants. Prior approval of NSE needed in case of deferment/cancellation Arbitration mechanism for resolving the disputes.

Commercial Papers (CPs)

Short-term unsecured usance promissory note Issued at a discount to face value by reputed companies with high credit rating and strong financial background. CPs are open to individuals, coporates, NRIs, banks and FIIs (on non-repatriable basis). Maturity of 15 days-1 year and are available in denomination of Rs 5 lakh and multiples thereof. Maturities on American CPs are a maximum of 270 days. Can be issued directly or through a merchant banker. Rating scale of credit rating firms is different Secondary market trading takes place by endorsement and delivery.

Certificate of deposits (CDs)

A promissory note issued by a bank entitling the bearer to receive interest. Negotiable instrument (endorsement & delivery) CDs bear a maturity date, an interest rate, and can be issued in any denomination. CDs < $100,000 called "small CDs," CDs > $100,000 called "large CDs/ "Jumbo CDs." American CDs are issued for a minimum of $100,000 of maturity of 30 days upto 5 years. Indian CDs issued for periods of 15 days - 1 year at a minimum amount of Rs 5 lakh and in multiples of Rs 1 lakh thereafter. Available on tap with the banks.

Repurchase Agreement (Repo)

A ready forward deal involving sale of a security with an undertaking to buy-back the same security at a predetermined price and time in future. To the seller it is known as a repo and to the buyer it is known as a reverse repo. Market participants are: banks, DFHI, financial institutions, non-banking entities like mutual funds that hold current and SGL accounts with RBI. Issued through acceptance of tenders, auction results and the payment. Maturities range from one to 90 days.

Mortgage Backed Securities (MBS)

An investment instrument that represents ownership of an undivided interest in a group of mortgages. Principal and interest from the individual mortgages are used to pay principal and interest on the MBS. Investors in MBS are effectively pooling their money and lending to a home buyer or business. MBS are a way for resource-deficit banks to lend mortgages to their customers. They act as intermediaries between the home buyer and the investment markets.

Collateralized Mortgage Obligations (CMOs)

An MBS that creates separate pools of passthrough rates for different classes of bondholders with varying maturities, called tranches. Repayments from the pool of pass-through securities are used to retire the bonds in the order specified by the bonds prospectus. Usually offer low returns as very low risk and sometimes backed by government securities.

Real Estate Investment Trust (REIT)

Sells like a stock on exchanges Invests in real estate directly, either through properties or mortgages. Receives special tax considerations Equity REITs: Equity REITS invest in and own properties (thus responsible for the equity or value of their real estate assets). Rrevenues from properties' rents. Mortgage REITs: Mortgage REITs deal in investment and ownership of property mortgages. These REITs loan money for mortgages to owners of real estate, or invest in (purchase) existing mortgages or mortgage backed securities. Their revenues are generated primarily by the interest that they earn on the mortgage loans. Hybrid REITs: Hybrid REITs combine the investment strategies of Equity REITs and Mortgage REITs by investing in both properties and mortgages. Over 300 publicly traded REITs operating in the US. Trade as stocks and offer dividends.