bond markets_trading and operations

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Bond Markets Trading & Operations

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Chapter 1: Bond Markets Introduction

IntroductionAbond is a debt instrument that:

Typically carries a specific rate of interest And a promise to repay the principal on maturity

Coupon the rate of interest on the bond when it was first issued

Annualized Coupon = [1+r/m] m -1

Where r is the stated interest rate and m is the compounding frequency.

Yield also an interest rate expressed as a return of investment.

Current Yield = (Annual Coupon Amount (in INR)/ Market Price)*100

Yield to Maturity (YTM) is the true yield in the bond markets and factors in the couponpayment, the capital gain/loss, and the reinvestment return of the coupon.

Yield curve

A yield curve gives the relationship between interest rate and term to maturity, at a specified

time. This could be positive, negative or flat.

The shape of the yield curve will change depending upon what happens to the long end of thecurve as compared to the short end on the bond in the secondary market. This will vary basedon market conditions Higher the price, lower the yield.

Trading involves taking a view on the level and the shape of the yield curve.

Floating interest rates

If the rate on the bond is varied or repriced at regular intervals, it is a floating rate bond. Thefloating rate is linked to a benchmark such as LIBOR or MIBOR.

The floating rate is reset two business days prior to the start of the interest period.

Credit rating

Evaluates the risk of default on a bond. The rating is expressed in the form of alphabets such asAAA, AA etc.


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Chapter 2: Bond Arithmetic

Day Count Conventions

Day count conventions tell us how to count the number of days between two interest dates,

and convert the number of days into a years fraction.

The different types are Act/360, Act/365, 30/360, Act/Act

Bond Pricing

The price of a bond is the present value of its future cash flows. To determine the bond price

we have to do the following:

The first step in bond pricing is to determine the cash flows on the bond. The next step is to find the present value of each of the future cash flows. To find the

present value, the discount rate to be taken is the market yield for the bond.

The formula looks like this:

P = C.F.1/ (1+y)1 + C.F.2/(1+y)2 + ...+ C.F.n/(1+y)n

If the price of the bond is known to you, you can compute the Yield To Maturity (YTM). YTM is

also known as the Internal Rate of Return (IRR) of the bond.

Clean price & Dirty price

Clean price is the quoted market price on the bond.

Dirty price includes the accrued interest paid by the buyer to the seller for the period the

seller held the bond during the coupon period. It is also called the full or settlement price.

Bonds Valuation

Pricing is the flip side of valuation. If you know how to price a bond, you just need to price itdaily using the prevailing market yield, to find out your (notional) profit or loss.


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Chapter 3: Indian Bond Market

Bonds in India can be classified based on:

The type of issuer.

The bond characteristics.

Central Govt. securities

Issued by the central government. They are all very safe investments as they are backed by the

central government.

Day Count Convention is: 30/360Coupon: semi-annual

T-Bills

The Government of India also issues securities called Treasury Bills or just T-Bills that have a

maturity < 1 year. They are also called Money Market securities as they are of short duration.

Day Count Convention: Actual/365.

No coupon.

State Government Securities

Although the majority of state funding comes through borrowings from the Central

Government, a significant amount of borrowing is also done by the state through capital

markets. These are called State Govt. securities.

Day Count Convention is: 30/360

Coupon: Semi-annual

Corporate Bonds

Bonds issued by corporations are called corporate bonds.Day Count Convention is: Act/365,

Coupon payment: Annual


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Types of Bonds

Callable Bonds: These are bonds where the issuer has the right to buy back the bonds. The

issuer will exercise if market rates are lower than coupon.

Puttable bonds: gives the investor the right to sell the bonds back to the issuer. The investor

will exercise if market rates are higher than coupon.

Convertible bonds: These are bonds that can be exchanged for specified amounts of common

stock, after a certain period of time.

Money Market Instruments

CDs: issued by banks to raise money.

CPs: issued by corporates to raise money. CPs are issued at a discount to face value.

Call Money market: The most liquid tenor for borrowing and lending transactions remains the

overnight market, which is called the call money market in India.

Repos:A repo is therefore, a secured borrowing. RBI uses the repo as an instrument of

monetary policy i.e., to signal interest rate changes.

CBLO: The call money market is limited only to inter-bank participants. Other participants like

mutual funds and corporates, with surplus liquidity, can participate in this market through the

Collateralised Borrowing and Lending Operation (CBLO) of the Clearing Corporation of India Ltd.

(CCIL).

India has one of the deepest bond markets with instruments ranging from a few days to 30

years.

Regulations

Primary market regulation is the responsibility of the RBI. In the secondary market, regulation is

divided between the RBI and the Securities and Exchange Board of India (SEBI).


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Market participants

Primary Dealers:The primary dealers were expected to provide two-way prices on all G-secs, as

well as to underwrite issues in the primary market

Other participants include PSU Banks, Private sector banks, insurance companies, mutual funds

etc.

Chapter 4: Issuance

The government does not come directly to the market to issue bonds and raise money. The RBI

acts as a facilitator and manages the entire issuance process for the government.

Bond issues are via an auction process.RBI announces an auction calendar for the year, based

on the fiscal deficit or borrowing requirement.

Bonds Auction Process

The auction process involves:

Auction notification:

This includes details like size of auction, details of securities to be auctioned etc.

Underwriting:

On a day prior to the auction bids, the primary dealers (PDs) must indicate the amount they are

willing to underwrite and the fees expected.

Actual acceptance of bids:

Bids are allowed till banking hours on the auction day, through the Negotiated Dealing System

(NDS) of the RBI. By the end of the same day, normally around 4:00 - 5:00 p.m, the results are

announced.

The RBI fixes a cut-off rate and all bids above that (for yield based auctions) and below that(for price based auctions) are rejected.

There are two variants of the auction process:

Dutch Auction- In a Dutch auction all successful bidders get the auction at the cut off price.


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French Auction- In a French auction, all the successful bidders get it at their respective bids.

For the G-secs, like for equities, you need to have a demat equivalent account. This is called a

SGL (Subsidiary General Ledger) account, and is maintained with the RBI.

The government also auctions T-bills of 91,182 & 364 day maturity.

Participants may also post non-competitive bids in an auction. Any non-competitive bids that

are met will be outside of the notified amount and at the discretion of the RBI. They are allotted

at the cut-off price.

The bonds issued by states follow the same convention as G-secs and are auctioned through

the RBI.

Corporate bonds are issued through a book building/private placement process, like equities.

An investment bank handles the entire issuance process and takes up the underwriting

commitment as well. For a small corporate, the bank may take the entire issue on to their own

books. They can later offload it to mutual funds and other players in the market and make a

spread.

Chapter 5: Pre Trade Analysis

Bond trading in India does not subject itself to technical analysis. The market is too illiquid (notenough price data) and imperfect for that. So, traders look at fundamentals.

Market Events

Budget:

The budget day fixes the fiscal deficit target for the coming year, and this helps determine the

size of the governments borrowing program. The budget is also the statement of performance

of the country. Hence, global credit rating agencies come up with the country rating, post

budget.

Credit Policy:

The credit policy is a statement from the RBI, on the interest rate outlook. It is announced

twice a year, in April and October (there are also two quarterly reviews of the policy). One gets

a feel of RBI's thinking - that is, an idea of where rates will trend in the future - in these policy

announcements. Traders should look at specific monetary measures announced by the RBI in


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terms of the policy rates. These refer to repo rates and the reserve requirements (CRR and

SLR).

Market Data

High Money supply & inflation affect interest rates adversely and thereby the bond markets. RBI

controls this through Open market operations (OMO), and by raising the policy rates such as

Repo & CRR.

CRR: A certain percentage of all deposits must be placed with the RBI in the form of cash.

SLR: A certain percentage of deposits to be invested in G-secs.

Other data that impact bond markets:

Credit growth High credit growth implies higher demand for funds implieshigher interest rates

Revenue shortfall Higher borrowings implies higher interest rates Auction cut-offs Higher yield cut offs indicates bearish sentiment in the market. Repo and reverse repo rates and figures Higher cash under reverse repo

implies surplus liquidity lower interest rates.

Bond markets in India also look at indications from the U.S economy on interest rate moves.

Any moves to lower interest rates there, will have a ripple effect in India as well. Similar data

such as U.S GDP, leading indicators of economic health such as Retail Sales, Unemploymentetc, must be analyzed.

Finally, currency markets also have an impact, due to central bank intervention. Buying and

selling of dollars has a rupee impact that must be neutralized.

Chapter 6: Trading

Trading Bonds involves trading three types of risk: Market Risk, Credit Risk & Liquidity Risk

Market risk refers to prices of bonds going up or down.

Credit risk is the default risk associated with the issuer of the bond. Liquidity risk is the inability to sell the bond in the secondary market when required

lack of buyers making the investment illiquid.


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Trading G-secs

For G-secs, that has only market risk, bond trading involves taking a view on:

Level of the yield curve relates to parallel shifts Shape of the yield curve relates to steepening or flattening of the curve

The shape of the yield curve will change depending upon what happens to the long end of the

curve as compared to the short end.

If the long end was to go up and short end remaining constant or lower, the curve is said to

have steepened

If the long end were to go down and the short end remaining constant or going up, the curve is

said to have flattened.

How do you trade on the shape of the yield curve?

If you expect the spread between say the 2 year and 7 year to widen, you would buy the 2

year bond and sell the 7 year bond. Auction trading

In a bullish market, traders would aggressively buy the auction tenor bond, to push downthe yields. Once the auction takes place at the lower cut-off market yields, trader would sell

the bond and book a profit.

The reverse would occur in case of a bearish market i.e. Sell the bond aggressively before the

auction to push up the yields.

Trading State Govt. securities

State Govt. securities tend to trade only in the primary market, with very little activity seen in

the secondary market. Normally, State Govt. bonds trade at a premium over the corresponding

GOI bond, as they technically carry a higher risk.


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Trading Corporate Bonds

Corporate bonds are not traded in the secondary market in absolute terms. What the market

looks at, or trades, is the spread between corporate bonds and the corresponding G-secs. The

traders bet on whether this spread is going to narrow or widen. This is similar to the yield curve

spreads trade, discussed in the G-sec section.

FX-MM Arbitrage

This is achieved by:

Borrowing USD at say 2% Swapping them into INR at say 3%, thereby generating risk free rupees at a total

cost of 5%.

Investing the rupee proceeds in short term G-secs such as T-Bills, at higher than5%.

Short Selling

As a measure to increase depth in the debt markets, the Reserve Bank of India permitted short

selling of Government securities.

The RBI has stated that intra-day short sale transaction and also the covering ofshort position should be executed only on the Negotiated Dealing System Order

Matching (NDS-OM) platform.

The guidelines initially permitted only intra-day short selling. This has howeverbeen extended to 5 days (T+ 5 days).

On settlement date, similar to equities, the short seller will need to borrow thesecurities.


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This may be done through the CCIL or directly between banks via a transactionsimilar to a repo.

Trade execution can happen in two ways in India:

Through the NDS Order Matching System (OMS) Through the Telephone

Bond Portfolio -Categories

A banks bond portfolio can be classified into three categories:

Held to Maturity (HTM): These are bonds, that are bought and held to maturity. For an HTM

portfolio, you need not value (MTM) the bonds daily. Hence, profit or loss on these bonds is not

calculated on a daily basis.

Held for Trading (HTM): Bonds in this portfolio, have to be valued (MTM) daily and must be

sold within 90 days of purchase.

Available for Sale (AFS): These are really in between the HTM and HFT category. The banks

intention here is

not to trade them frequently (limit of 90 days does not apply here), not to hold them to maturity

Chapter 7: Post Trade & Asset servicing

Trade Capture

The first step in the post trade process is Deal Capture. This refers to basic details such as

Trade date, Value date, Operation, Quantity, price etc.

The deal capture system then validates that all necessary components of a trade are

present

The trade is then checked and authorized by the front office (trading desk).


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The successful capture of a trade should result in the trade details being sent to the

back office immediately for operational processing.

The next step is the verification of the trade with the contract slip. This is done by theback office. In case of errors, the deal is sent back to the front office for rectification.

Prior to enrichment, the system updates the position.

Position must be reconciled, because on the date of the trade, the trading position will change,

but these securities position will not, as the securities will reach or leave your account only on

settlement date.

Securities can be:

Held in SGL a/c with RBI rep by -ve sign

Yet to be delivered to SGL a/c (purchase) rep by -ve sign

Yet to be delivered from SGL a/c(Sale) rep by +ve sign

Trade Enrichment

Trade enrichment involves the selection, calculation, and attachment to a trade, of any other

information necessary for trade completion and settlement.

Trade Validation

A final validation of the trade details done at this stage

Trade Agreement

After the trade validation process, the next immediate step is the act of gaining agreement of

the trade details with the counterparty.

Settlement Instructions

As the settlement agency is CCIL, and the final settlement takes place through the SGL a/c at

RBI, no express settlement instructions need to be sent.


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Trade Settlement

The settlement basis is Delivery Versus Payment (DVP). That is, simultaneous settlement of

securities and cash, on a net basis.

Post Trade Corporate Bonds

Corporate bonds, though traded OTC, are reported to the stock exchange using the Corporate

Bond Reporting and Integrated Clearing System (CBRICS platform) of FIMMDA.

Trades are settled on a gross basis directly between participants on delivery versus payment

basis.

Asset Servicing

This relates to coupon and principal repayments, and in case of a convertible bond the

conversion into equity shares.

Chapter 8: Risk Management

The various risk parameters to evaluate a bond portfolio are:

PV01/PVBP Macaulays Duration

Modified Duration

Convexity

PV01/PVBP

If the market yields on the bond changes by 1 basis point, then the change in price for that

one basis point is known as PV01.

How do you measure PVBP?

Step 1: Price the bond at the current YTM.

Step 2: Change the YTM up or down by 1 bp (0.01% or 0.0001).

Step 3: Find the new price and calculate the difference.


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Macaulays Duration

Duration is, the weighted average term to maturity of a bonds cash flows. It is a measure in

years, of how long it will take to recover the cash flows (coupon + principal) on the bond. As

there are some intermediate coupon cash flows, duration will always be less than the maturity

of the bond.

The formula for calculating duration is:

[(PVCF/TPVCF)*T]

Where, PVCF is the present value of each cash flow.

TPVCF is the total present value of the cash flows, which is also the bond price.

T is the time period of the cash flow expressed in years.

Portfolio Duration

The above formula gives the duration of a single bond. If you want the duration of the portfolio,

you do the weighted average of the weighted average. The weights used are the market value

of each bond to the total portfolio value.

Modified Duration

Duration for risk management purposes should be more accurately defined as a measure of

sensitivity ofa bonds value to rate changes.

The market thus uses a measure called modified duration, which is

[Macaulay Duration]/[1 + (Yield/k)]

Where k is the number of interest periods in a year.

Specifically, it is the percentage change in the bond price for a 100 bps change in rates.

Convexity

The change in the bond price for a change in yield is not linear. i.e. % change in price for a 1bp

change is not 100 times the change for a 100 bps change.

This difference is explained by Convexity.


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This measure called the Convexity Adjustment is computed in two steps:

Step 1:Determine the convexity measure

(PVCF/TPVCF)*T2i.e. multiply the duration value by T again.

Step 2:Determine the Convexity Adjustment

(Convexity measurement/2)*(y)2* 100,Where y is the change in yield.

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