debt primer ppt

8/6/2019 Debt Primer Ppt

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Basics of FixedBasics of Fixed

Income InvestingIncome Investing


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The Nature of DebtThe Nature of Debt

Debt instruments are investment options where anDebt instruments are investment options where aninvestor invests with the assurance of fixed income andinvestor invests with the assurance of fixed income and

protection of principalprotection of principal A debt instrument represents a loan contract between theA debt instrument represents a loan contract between the

issuer and the investor under which the issuer isissuer and the investor under which the issuer isconsidered to have borrowed money from the investorconsidered to have borrowed money from the investor

Th

e issuer promises to pay back this amount by a pre

The issuer promises to pay back t

his amount by a pre--specified datespecified date

Additionally, the issuer also promises to pay interest onAdditionally, the issuer also promises to pay interest onthe borrowed money on prethe borrowed money on pre--specified datesspecified dates


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Key Characteristics of DebtKey Characteristics of Debt

IssuerIssuer: The issuer is usually the Central Government or: The issuer is usually the Central Government orState Governments (Government Securities) or aState Governments (Government Securities) or a

Corporate (Corporate Bonds).Corporate (Corporate Bonds).

MaturityMaturity: The period at the end of which the instrument: The period at the end of which the instrumentwill be redeemed.will be redeemed.

CouponCoupon: The interest that will be paid.: The interest that will be paid.

Usually paid at regular intervals i.e. monthly, halfUsually paid at regular intervals i.e. monthly, half--yearly, yearly.yearly, yearly. (Exception: Zero Coupon Bonds)(Exception: Zero Coupon Bonds)

Usually specified in absolute terms.Usually specified in absolute terms. (Exception: Floating(Exception: FloatingRate Bonds)Rate Bonds)


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Key Characteristics of DebtKey Characteristics of Debt

Par ValuePar Value: The reference amount for calculating the: The reference amount for calculating the

return. Usually it is the amount paid back to the investorreturn. Usually it is the amount paid back to the investorat maturity.at maturity.

Other FeaturesOther Features::

Put/ Call DatesPut/ Call Dates: Pre: Pre--specified dates (before maturity)specified dates (before maturity)

on which the investor can ask for his money back (put)on which the investor can ask for his money back (put)or the issuer can compulsorily redeem the bond (call).or the issuer can compulsorily redeem the bond (call).

ConvertibilityConvertibility: An option to convert part or all of the: An option to convert part or all of therepayable amount into shares.repayable amount into shares.


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Estimating Returns on DebtEstimating Returns on Debt

InvestmentsInvestments

Returns on debt investments tend to be moreReturns on debt investments tend to be more

predictable, as compared to equities.predictable, as compared to equities.

Debt investments tend to have lesser variability inDebt investments tend to have lesser variability inreturns, as compared to equities*.(Ifheld till Maturity)returns, as compared to equities*.(Ifheld till Maturity)

Past returns of any asset class are not necessarily anPast returns of any asset class are not necessarily an

indicator of the future prospects. This is much more theindicator of the future prospects. This is much more thecase with debt investments.case with debt investments.


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Calculating the Expected ReturnCalculating the Expected Return

Case 1Case 1: Investing in a debt instrument at the time of: Investing in a debt instrument at the time ofissueissue

Case 2Case 2: Investing in a debt instrument in the secondary: Investing in a debt instrument in the secondarymarketmarket

Case 3Case 3: Investing in a Debt Mutual Fund: Investing in a Debt Mutual Fund


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Ifheld till maturity, theIfheld till maturity, the

return expected willreturn expected willdepend on:depend on:

Coupon IncomeCoupon Income

Upfront Discount, if anyUpfront Discount, if any

Redemption Premium, ifRedemption Premium, ifanyany

If sold before maturity,If sold before maturity,

the return expected willthe return expected willdepend on:depend on:


Upfront Discount, if anyUpfront Discount, if any

Sale PriceSale Price

Case 1: Investing in a Debt Instrument at the time of issueCase 1: Investing in a Debt Instrument at the time of issue


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ExampleExample

Mr. Mc Grath is considering investing 300,000 in theMr. Mc Grath is considering investing 300,000 in the

monthly income option of a new bond issue. The bondsmonthly income option of a new bond issue. The bondshave a par value of 100,000 and are offering a couponhave a par value of 100,000 and are offering a couponincome of 800 per month and will be redeemed at par atincome of 800 per month and will be redeemed at par atthe end of 6 years.the end of 6 years.

A friend suggests he invest instead in the Post Office MISA friend suggests he invest instead in the Post Office MISwhere he will get a income of 2000 per month and awhere he will get a income of 2000 per month and apremium of 10% on redemption at the end of 6 years.premium of 10% on redemption at the end of 6 years.

Which option offers a better effective return?Which option offers a better effective return?


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SolutionSolution

Return from new bond issueReturn from new bond issue

PV = Amount to be Invested =PV = Amount to be Invested = --300,000300,000

PMT = Monthly Income = 2,400PMT = Monthly Income = 2,400

NPER = No of Months ofholding = 72NPER = No of Months ofholding = 72

FV = Redemption Value = 300,000FV = Redemption Value = 300,000

AnnualizedAnnualizedRate of ReturnRate of Return

9.60%9.60% p.a.,p.a.,compounded annuallycompounded annually

10.03%10.03% p.a.,p.a.,compounded monthlycompounded monthly

Total Income ReceivableTotal Income Receivable172,800172,800


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SolutionSolution

Return from Post Office MISReturn from Post Office MIS

PV = Amount to be Invested =PV = Amount to be Invested = --300,000300,000

PMT = Monthly Income = 2,000PMT = Monthly Income = 2,000

NPER = No of Months ofholding = 72NPER = No of Months ofholding = 72

FV = Redemption Value = 330,000FV = Redemption Value = 330,000

AnnualizedAnnualizedRate of ReturnRate of Return

9.25%9.25% p.a.,p.a.,compounded annuallycompounded annually

9.66%9.66% p.a.,p.a.,compounded monthlycompounded monthly

Total Income ReceivableTotal Income Receivable174,000174,000


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CommentComment

In t his case, the Post Office MIS actually offered a greaterIn this case, the Post Office MIS actually offered a greatertotal income than the new bond issue. The annualizedtotal income than the new bond issue. The annualizedreturns factors in the time value of money.returns factors in the time value of money.

The annualized returns, as calculated, are also referred toThe annualized returns, as calculated, are also referred toas Yield to Maturity (YTM). The term YTM is used onlyas Yield to Maturity (YTM). The term YTM is used onlywhen one assumes the bond will be held till maturity.when one assumes the bond will be held till maturity.

Estimating the return on a bond on the assumption thatEstimating the return on a bond on the assumption that

one sells in the secondary market, will require anone sells in the secondary market, will require anestimate of the price one will get at that point.estimate of the price one will get at that point.

The price one will get will depend on the YTM that aThe price one will get will depend on the YTM that apotential buyer at that point would expect.potential buyer at that point would expect.


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Case 2: Investing in a Debt Instrument in the Secondary MarketCase 2: Investing in a Debt Instrument in the Secondary Market


return expected (or YTM)return expected (or YTM)will depend on:will depend on:

Purchase PricePurchase Price


Redemption Premium, ifRedemption Premium, ifanyany


the return expected willthe return expected willdepend on:depend on:

Purchase PricePurchase Price



When investing in the secondary market, very often the key issue is knowingWhen investing in the secondary market, very often the key issue is knowingwhat would be a fair price for a bond, given the YTMof comparable bonds ofwhat would be a fair price for a bond, given the YTMof comparable bonds of

identical maturity.identical maturity.


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Estimating the Right PriceEstimating the Right Price

Case 2: Investing in a Debt Instrument in the Secondary MarketCase 2: Investing in a Debt Instrument in the Secondary Market


price will depend on:price will depend on:YTMexpectedYTMexpected


Redemption Premium, ifRedemption Premium, if

anyany


the price will dependthe price will dependon:on:

YTMexpectedYTMexpected




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ExampleExample

Mr. Sehwag is considering investing in a bond in theMr. Sehwag is considering investing in a bond in the

secondary market. The bond will be redeemed after 2secondary market. The bond will be redeemed after 2years at its par value of 100. The bond will be paying ayears at its par value of 100. The bond will be paying acoupon income of 4 per bond, every six months.coupon income of 4 per bond, every six months.

Currently, comparable bonds of similar maturity areCurrently, comparable bonds of similar maturity are

available at a YTM of 7.50% p.a.available at a YTM of 7.50% p.a. What would be a fair price for Mr. Sehwag to pay for thisWhat would be a fair price for Mr. Sehwag to pay for this

bond?bond?


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ExampleExample

Inputs for Estimating Fair PriceInputs for Estimating Fair Price

NPER = No of Six Monthly periods = 4NPER = No of Six Monthly periods = 4

PMT = Half yearly Coupon Income = 4PMT = Half yearly Coupon Income = 4

FV = Maturity Value = 100FV = Maturity Value = 100

RATE = YTM = 7.50% p.a.RATE = YTM = 7.50% p.a.

Fair Price of BondFair Price of Bond

101.16101.16


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Case 3: Investing in a Debt FundCase 3: Investing in a Debt Fund

The return expectedThe return expected

will depend on:will depend on:YTM of fund portfolioYTM of fund portfolio

Fund expensesFund expenses

Scope for fundScope for fund

manager to makemanager to maketrading gainstrading gains

The YTM of a fund portfolioThe YTM of a fund portfolio

is based on the cash flows ofis based on the cash flows ofthe underlying securities.the underlying securities.

Scope for trading gainsScope for trading gainsdepends on the funddepends on the fund

structure and style. Moststructure and style. MostFMPs, for instance, offerFMPs, for instance, offerlimited scope for such gains.limited scope for such gains.


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ExampleExample

Smart Income Fund and Great Income Fund are two openSmart Income Fund and Great Income Fund are two openend debt funds with identical objectives and managed inend debt funds with identical objectives and managed insimilar style by their respective fund managers.similar style by their respective fund managers.

Smart Income Fund currently has a YTM of 8.50% and anSmart Income Fund currently has a YTM of 8.50% and anexpense ratio of 1.60%. Great Income Fund has a YTM ofexpense ratio of 1.60%. Great Income Fund has a YTM of8.25% and an expense ratio of 1.00%.8.25% and an expense ratio of 1.00%.

Based on this information, which fund can be expected toBased on this information, which fund can be expected to

deliver better returns?deliver better returns?

Great Income Fund. The YTM (net of expenses) is 7.25%Great Income Fund. The YTM (net of expenses) is 7.25%as compared to 6.90% for Smart Income Fund.as compared to 6.90% for Smart Income Fund.


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Risks of Investing in DebtRisks of Investing in Debt

The risks that affect Debt investments tend to be differentThe risks that affect Debt investments tend to be differentfrom the risks affecting Equities.from the risks affecting Equities.

While there are a variety of risks that affect DebtWhile there are a variety of risks that affect Debt

investments,here we will focus on two key risks:investments,

here we will focus on two key risks:

CreditRisk (or Issuer Risk)CreditRisk (or Issuer Risk)

InterestRate RiskInterestRate Risk


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Issuer Risk / CreditRiskIssuer Risk / CreditRisk

CreditRisk is the risk that the issuer will not pay theCreditRisk is the risk that the issuer will not pay thecoupon income and/ or the maturity amount on thecoupon income and/ or the maturity amount on thespecified dates.specified dates.

Credit RatingsCredit Ratings have been established by rating agencieshave been established by rating agencies(such as CRISIL & ICRA) to reflect their opinion of an(such as CRISIL & ICRA) to reflect their opinion of anissuers ability and willingness to do so.issuers ability and willingness to do so.

The rating is issue specific and can change with a changeThe rating is issue specific and can change with a change

in the issuers perceived ability and willingness to meetin the issuers perceived ability and willingness to meetfinancial commitments.financial commitments.

In India, securities issued by the Central GovernmentIn India, securities issued by the Central Government(sovereign debt) carry the highest credit safety.(sovereign debt) carry the highest credit safety.


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InterestRate Risk is the risk that interest rates may rise,InterestRate Risk is the risk that interest rates may rise,

causing a fall in value of traded debt instruments.causing a fall in value of traded debt instruments.

The price of a bond in the secondary market is determinedThe price of a bond in the secondary market is determined

by the YTM that potential buyers expect at that point. Ifby the YTM that potential buyers expect at that point. Ifinterest rates go up, the YTM expected will also increase,interest rates go up, the YTM expected will also increase,

which will bring down the price such buyers will be willingwhich will bring down the price such buyers will be willing

to pay.to pay.

Interest RatesInterest Rates Bond PricesBond Prices


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InterestRate Risk affectsInterestRate Risk affects

investors in bonds who do not plan to hold their bondsinvestors in bonds who do not plan to hold their bondstill maturitytill maturity

investors in most debt funds with markinvestors in most debt funds with mark--toto--marketmarketportfoliosportfolios

To measure interest rate risk, the most commonly usedTo measure interest rate risk, the most commonly used

metric ismetric is DurationDuration.. Duration is arrived at by factoring in a bonds couponDuration is arrived at by factoring in a bonds coupon

payments, principal repayment, YTM and paymentpayments, principal repayment, YTM and paymentschedule.schedule.


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Effect on DurationEffect on Duration

Fixed CouponFixed Coupon ==HigherHigherDurationDuration

Longer MaturityLonger Maturity ==HigherHigher

DurationDuration

Higher Coupon RateHigher Coupon Rate ==LowerLowerDurationDuration

More Frequent CouponMore Frequent CouponPaymentsPayments ==

LowerLowerDurationDuration

If interest rates change, the higher the Duration, the more aIf interest rates change, the higher the Duration, the more abonds price (or a Debt Funds NAV) will movebonds price (or a Debt Funds NAV) will move


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Modified DurationModified Duration

% Change

in

Bond Price

= -(Duration)

Change

in

Interest Rate

x

Inverse Relationship between interest rate & bond price changes

There is no single, universally accepted method forThere is no single, universally accepted method forcalculating Duration; a variety of methods are used. Onecalculating Duration; a variety of methods are used. One

of the most common is known asof the most common is known as Modified DurationModified Duration.. Modified Duration measures the expected percent changeModified Duration measures the expected percent change

in a bonds price (or a Debt Funds NAV) for every percentin a bonds price (or a Debt Funds NAV) for every percentchange in interest rates.change in interest rates.


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Modified DurationModified Duration

If Int. RateRISES

by 1%...

Bond Price

will FALL

by 3.5%

What would a Modified Duration ofWhat would a Modified Duration of

3.5 years signify?3.5 years signify?If Int. Rate

FALLS

by 5%...

Bond Price

will RISE

by 17.5%


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Choosing the Right Debt FundChoosing the Right Debt Fund

A logical approach to picking the right fund will involveA logical approach to picking the right fund will involvelooking at potential return and potential risks.looking at potential return and potential risks.

Unlike equities there are no universally acceptedUnlike equities there are no universally acceptedmeasures of riskmeasures of risk--adjusted return for debt funds.adjusted return for debt funds.

A good starting point for assessing potential return isA good starting point for assessing potential return islooking at each funds YTM (less expenses).looking at each funds YTM (less expenses).

The potential risksThe potential risks credit risk and interest rate riskcredit risk and interest rate risk willwill

have to be quantified and accorded weightages on a casehave to be quantified and accorded weightages on a caseto case basis.to case basis.

The final decision will involve matching the potentialThe final decision will involve matching the potentialreturn with the potential risks.return with the potential risks.


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Risk FactorsRisk Factors

All investments in mutual funds and securities are subject to market risks and

the NAVs of the schemes may go up or down depending upon the factors

and forces affecting the securities market. There can be no assurance thatthe schemes investment objectives will be achieved. The past

performance of the mutual fund managed by the Religare Mutual Fund is

not necessarily indicative of future performance of the schemes. The name

of a scheme does not in any manner indicate the quality of the scheme, its

future prospects or returns. The investment made by a scheme are subject

to external risks. Please read the offer document carefully beforeinvesting. The Fund offers NAVs, purchases and redemptions on all business

days except during book closure

debt primer ppt

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