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What are the terminologies in Debt Market?

Debt capital indicates to the capital offered by the lenders who are enthusiastic to be rewardedfrequently in the form of a pre-specified fixed rate of interest.

They also anticipate the money they have lent to be returned to them after adecided period of time.

Debt can be shaped by borrowing from banks and other institutions or by issuing debt securities.

For instance, if a company needs to borrow Rs. 100 crores, it has two choices. If it takes a bank loan for the total amount, then the bank, or consortium of bankers, is the solitary lender to the company.

Alternately, it can access a larger pool of investors by breaking up the loan amount into smaller denominations.

Each Debt will face value of Rs.100 if it issues 1 crore, then an investor who brings in Rs. 1000 would receive 10 securities. The lending exposure of each investor is restricted to the extent of his investment.

A debt security represents a contract between the issuer (company) and the lender (investor) which permits the issuer to borrow a sum of money at preset terms. These terms arereferred to as the characteristics of a debt security and include the principal, coupon, the maturity of the security and the security, if any, provided for the lending.

All debt securities grant the investor the right to coupon payments and principal repayment as per the debt contract.

A few debt securities, known secured debt, also give investors rights over the assets of the issuing company.

If there is a non-payment on interest or principal payments, those assets can be sold to repay the investors. This option is not applicable to Investors with unsecured debt.

Debt securities may be privately placed with a select group of investors or offered to public through a public issue of the securities.

Debt securities that are issued in a public issue are mandatorily listed on stock exchanges such as National Stock Exchange or Bombay Stock Exchange, so that they can be traded in the secondary market.

Unlisted securities have to be held until maturity or traded in the Over the counter (OTC) market.

Some of the frequently used terms of debt instruments are mentioned below:

Face Value

Any debt instrument cannot be whollydescribed without responding how much borrowing it represents, for how long has the money been lent and what is the interest rate on the same.

The first question is answered by the term Face Value, which signifies how much loan is symbolized by that particular debt paper.

This is the nominal or par value of the debt paper and interest, throughout the term of the paper, is paid as a percentage of this amount. The face value may be Rs. 100 or Rs. 1000 or any other denomination.

Coupon Rate

Interest paid on the bond/debt security is called as Coupon rate, articulated as a percentage of its face value.

The actual amount of money which the investor receives as interest is equal to the product of the face value and the coupon rate.

Consequently a 8.24% GS2018 read as 8.24% coupon bearing Government Security (G-Sec) maturing in 2018) with face value Rs. 1000, would pay Rs. 82.40 as coupon (interest) each year, till maturity, to the investor.

G-Secs pay interest semi-annually. Under these circumstances, the investor would get Rs. 41.2 (82.4/2) every 6 months.

The last coupon payment will be received on the maturity date along with the principal (par value).

All the way through the period for which the bond is held, the investor would receive coupon payments.

These coupons may be re-invested to earn interest at the rate widespread at the time of re-investment.

Moreover, the investor will make a gain or loss at the time of selling the bond based on whether the sale price is higher or lower than his purchase price.

Adding all these three incomes and expressing it as a percentage of the cost price will be treated as the HPR for the investor.

When an investor purchases a bond at Rs. 104, earns Rs. 8 as coupon, which is reinvests at 7% for 1 year by him, eventually he sells the bonds at RS. 110 after 1 year then his

HPR would be:

HPR = [(8) + (8 * 7%) + (110-104)]/ 104 = 14.00%

HPR is single period return and does not annualize the return to the investors.

Current Yield

This is a simple technique of calculating return on a debt security in which the coupon is divided with the current market price of the bond and the result is expressed as percentage.

This technique does not consider future cash flows coming from the bond, which is the biggest disadvantage of this process and therefore this technique is not really used widely. It can be measured up to the dividend yield of a stock.

Suppose the 8.24% GS2018 is trading at Rs. 104, the current yield would be:

Current Yield = (8.24/104) = 0.07923 = 7.92%

Yield to Maturity (YTM):

Yield to Maturity or YTM is a more complete and broadly used measure of return calculation of a debt security than current yield.

This process takes into reflection all future cash flows coming from the bond -coupons plus the principal repayment and associates the present values of these cash flows to the prevailing market price of the bond.

The rate which associates the present outflow (price of the bond which the investor needs to pay in order to purchase the bond) with the present value of future inflows (coupons plus principal) is called as YTM. Consequently, it can be implicit as the Internal Rate of Return (IRR) of the bond.

The YTM can be calculated by trial and error method by pointing in diverse rates in the equation and arriving at the one that associates the market price of bond to the present value of the expected cash flows from the bond.

YTM, regardless of the fact thatit is better than current yield, and also extensively used, has its own limitation.

Primarily, it presumes that the investor will hold the bond till maturity, which may or may not be the circumstance.

Secondly, it presumes that the coupons received at regular intervals are reinvested for the remaining tenor of the bond at the same rate throughout the tenor.

This hypothesisentails that interest rates would stay on same for the entire tenor and that the rates would also be same across tenors, which indicates that the yield curve would be still and flat.

This hypothesis takes YTM away from being realistic. On the other hand, YTM has its own reward, biggest of which being that it is uncomplicated and quick calculation and therefore it is widely used.

Duration

Duration measures the understanding of the price of a bond to changes in interest rates.

Bonds with high duration experience greater increases in value when interest rates turn down and greater losses in value when rates raise, compared to bonds with lower duration.

Duration is the weighted average maturity of the bond, where the present values of the future cash flows are used as weights. Duration consequently incorporates the tenor, coupon and yield in its calculation.

Higher the time to maturity, higher the duration and hence higher the interest rate risk of the bond.

Lower the coupon rate, higher the duration and for this reason higher the interest rate risk of the bond. And, Lower the yield, higher the duration and for this reason higher the interest rate risk of the bond.

Therefore, Duration is a very suitable interest rate risk measure for bonds. Higher the duration higher the sensitivity of bonds prices vis a vis interest rate.

The duration of a bond is not a stagnant number, but will change with a change in the tenor and yield of the bond.

As a bond comes closer to maturity, its duration also decreases and makes the bond less risky.

Modified Duration (M Duration)

Modified Duration measures the collision of changes in interest rates on the price of the bond.

While Duration gives us sensitivity of bond prices to change in interest rates, Modified Duration gives us the magnitude of this change.

M Duration is calculated as:

M Duration (D*) = - Duration/ (1 + YTM)

The negative sign relates the inverse relationship between bond prices and interest rates.

When interest rates rise, bond holders go through a drop in the price of bonds they hold which pay a lower coupon rate on their principal, as contrast to new bonds which would be issued in line with higher interest rates.

New buyers of bonds would not pay the same price for the old bonds, as for the same investment in new bonds, they would get a higher coupon.

To bring both the bonds at the same level, the prices of old bonds would fall so that the yield on these bonds is same as the yield on the new ones.

Likewise, when rates drop, the old bonds with high coupon rates would become striking by the same reason.

Change in price of a bond would be calculated as the product of M Duration and percentage change in yield.

Suppose a bond has M Duration of 4.3, then a small change of 0.25% (25 basis points or 25 bps) would mean the price of the bond would change by (4.3 * 25/100) = 1.075% in the opposite direction.

Convexity

The collision of change in interest rates on bond prices is inverse but not linear. This way when rates go up, bond prices go down; but they don’t drop as much as they would rise when rates go down by the same magnitude.

Consequently, increase in bond prices is more than its drop, for the same movement in interest rates in downward and upward directions correspondingly.

This soleproperty of bond prices is called as Convexity. It must be eminent that M Duration is applicable only for small changes in interestrates as for larger changes; it would show a straight-line movement in prices, which would be incorrect.

Therefore, M Duration is only useful at that point where the straight line would be peripheral to the price yield curve.

Bond fund managers look for bonds with high convexity as these do not drop much in rising interest rate circumstances but rise more when rates are falling.

This can be better understood by the illustration below:

Assume a circumstance where a bond with maturity of 2 years is trading at Rs. 100 initially. This will happen when Coupon and YTM are same (presume 8%).

When we raise the YTM to 9%, the price of the bond drops to Rs. 98.21; i.e. a drop of 1.79%, while if the YTM were to drop by the same magnitude, 1%, the bond price rises by 1.83% to Rs. 101.83.


Settlement Date 20-Nov-14 20-Nov-14 20-Nov-14
Maturity Date 19-Nov-16 19-Nov-16 19-Nov-16
Coupon 8% 8% 8%
Yield (YTM) 8.00% 9.00% 7.00%
Frequency of Int. payment 2 2 2
Face Value 100 100 100
Price 100 98.21 101.83
Change in Price -1.79% 1.83%

For this reason, we can see that rise and drop in bond prices for same change in YTMs is not linear but convex.

As mentioned above, bonds drop less for rise in interest rates than they rise for a drop in the interest rates of same magnitude.

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