INDEX

Sr. No. Topic Page No.

1 Introduction 2-5

2 Types of Bonds 6-10

3 Term Structure 11-18

4 Coupon Rate Determinant 19-22

5 Interest Rate Risk Management 23-25

6 Risk Associated with Bonds 26-28

7 Difference between Bond Market & Stock Market

29-31

8 Bonds on NYSE 32-36

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INTRODUCTION

A bond is a security instrument which acknowledges that the issuer has borrowed money and must repay it to the bondholder at a specified rate of interest over a predetermined period of time. These securities are referred to as debt obligations, contrasted with stocks, which represent ownership in a corporation. Bonds fall into the three categories of their issuers: corporations; the U.S. government and its agencies; and states, municipalities, and other local governments. Each has features and advantages which should be evaluated when deciding upon which type of bond best suits your investment needs.

The interest that a bond pays is called its yield; it’s expressed as a percentage of the bond’s face value. For example, a $5,000 bond with an 8% yield would pay $400 in interest per year. Because the income from a bond doesn’t change from year to year, it’s known as a fixed-income security. The interest can be paid out in yearly payments, or coupons; bonds which do not pay out yearly but pay the principal and all accumulated interest at maturity are known as zero-coupon bonds.

It is important to be aware of the fundamental relationship between a bond’s yield and its maturity (the predetermined time for payback). Longer maturities generally translate to higher yields, because of the increased potential that, Sover time, a rise in interest rates will lower the bond’s price. Generally, bond prices move in the opposite direction of interest rates. If rates go up, the price of bonds declines. Conversely, when interest rates go down, bond prices rise.

Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificates of deposit (CDs) or commercial paper are considered to be money market

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instruments and not bonds. Bonds must be repaid at fixed intervals over a period of time.

Bonds and stocks are both securities, but the major difference between the two is that (capital-) stockholders have an equity stake in the company (i.e., they are owners), whereas bondholders have a creditor stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).

Issuing Bonds

Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by bookrunners who arrange the bond issue, have the direct contact with investors and act as advisors to the bond issuer in terms of timing and price of the bond issue. The bookrunners' willingness to underwrite must be discussed prior to opening books on a bond issue as there may be limited appetite to do so.

In the case of Government Bonds, these are usually issued by auctions, where both members of the public and banks may bid for bond. Since the coupon is fixed, but the price is not, the percent return is a function both of the price paid as well as the coupon.

Features of Bonds

The most important features of a bond are:

Nominal, Principal Or Face Amount: The amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of

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particular assets such as a stock or commodity index, foreign exchange rate or a fund. This can result in an investor receiving less or more than his original investment at maturity.

Issue Price : The price at which investors buy the bonds when they are first issued, which will typically be approximately equal to the nominal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees.

Maturity Date : The date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligation to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in euros for bonds with a maturity of fifty years.

In the market for U.S. Treasury securities, there are three groups of bond maturities:

short term (bills): maturities up to one year; medium term (notes): maturities between one and ten years; long term (bonds): maturities greater than ten years.

Coupon : The interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.

The "quality" of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates. This will depend on a wide range of factors.

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Indentures and Covenants — An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the U.S., federal and state securities and commercial laws apply to the enforcement of these agreements, which are construed by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bondholders.

High yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are more risky than investment grade bonds, investors expect to earn a higher yield. These bonds are also called junk bonds.

Coupon Dates — the dates on which the issuer pays the coupon to the bond holders. In the U.S. and also in the U.K. and Europe, most bonds are semi-annual, which means that they pay a coupon every six months.

Optionality: Occasionally a bond may contain an embedded option; that is, it grants option-like features to the holder or the issuer:

Callability — Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.

Putability — Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates;

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see put option. (Note: "Putable" denotes an embedded put option; "Puttable" denotes that it may be put.)

Call Dates And Put Dates—the dates on which callable and putable bonds can be redeemed early. There are four main categories.

I. A Bermudan callable has several call dates, usually coinciding with coupon dates.

II. A European callable has only one call date. This is a special case of a Bermudan callable.

III. An American callable can be called at any time until the maturity date.

IV. A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation. Also known as a "survivor's option".

Sinking Fund provision of the corporate bond indenture requires a certain portion of the issue to be retired periodically. The entire bond issue can be liquidated by the maturity date. If that is not the case, then the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in open market, then return them to trustees. Bonds can be classified into following types depending on the type of issuer.

Domestic Bonds: Domestic bonds are bonds which are issued within the domestic market and are denominated in the domestic currency. These are issued by a local borrower. For instance, State bank of India issuing bonds to Indian residents.

Foreign Bonds: These types of bonds are again denominated in domestic currency and in the local market, only difference being a foreign borrower. Examples are:

Yankee bonds: Issued in US by a foreign borrower and are denominated in US

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Samurai bonds: Issued in Japan by a foreign borrower and are denominated in Japanese Yen

Eurobonds: Eurobonds are bonds which are denominated in foreign currency and are issued by a foreign firm and sold to the home country residents. For instance, A US denominated bond issued by a US firm in UK is a euro bond.

Global bonds: These bonds are sold to many other markets as well as Euromarkets. Global bonds can be issued in same currency as the country of issuance, which is not the case with euro bonds,

Floating Rate bonds: Floating rate bonds are popularly known as floaters and are bonds interest rates of which depends on some reference rate. For example, coupon rates based on LIBOR can be LIBOR+ Quoted margin. These interest rates are then reset periodically. In other words, coupon rates are based on the rate calculated on the reset date.

Floaters can have special features like caps, floors and collars.

Caps: It specifies the maximum coupon rate of the floater. This is attractive for the issuer as it restricts his liability and is therefore not so attractive for the investor.

Floors: Similar to caps, floors specify the minimum rate of coupon and is therefore attractive for the investor.

Collars: These are combinations of caps and floors.

There are also floaters known as Inverse Floaters. They are different from regular floaters in that they have coupon rates which are based on opposite direction of reference rate. They can be represented as (some fixed percentage)-reference rate.

There can also be Dual Indexed floaters which are based on more than one reference rates.

Some more types of bond are as follows.

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Convertible Bond lets a bondholder exchange a bond to a number of shares of the issuer's common stock.

Exchangeable Bond allows for exchange to shares of a corporation other than the issuer.

The following descriptions are not mutually exclusive, and more than one of them may apply to a particular bond.

Fixed Rate Bonds have a coupon that remains constant throughout the life of the bond.

Floating Rate Notes (Frns) have a variable coupon that is linked to a reference rate of interest, such as LIBOR or Euribor. For example the coupon may be defined as three month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months.

Zero-Coupon Bonds pay no regular interest. They are issued at a substantial discount to par value, so that the interest is effectively rolled up to maturity (and usually taxed as such). The bondholder receives the full principal amount on the redemption date. An example of zero coupon bonds is Series E savings bonds issued by the U.S. government. Zero-coupon bonds may be created from fixed rate bonds by a financial institution separating ("stripping off") the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond may be traded separately. See IO (Interest Only) and PO (Principal Only).

Other Indexed Bonds, for example equity-linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.

Asset-Backed Securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs).

Subordinated Bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a

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hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.

Perpetual Bonds are also often called perpetuities or 'Perps'. They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today, although the amounts are now insignificant. Some ultra-long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century)) are virtually perpetuities from a financial point of view, with the current value of principal near zero.

Bearer Bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets. U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local tax-exempt bearer bonds were prohibited in 1983.

Registered Bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner.

Municipal Bond is a bond issued by a state, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.

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Book-Entry Bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them.

Serial Bond is a bond that matures in installments over a period of time. In effect, a $100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval.

Revenue Bond is a special type of municipal bond distinguished by its guarantee of repayment solely from revenues generated by a specified revenue-generating entity associated with the purpose of the bonds. Revenue bonds are typically "non-recourse," meaning that in the event of default, the bond holder has no recourse to other governmental assets or revenues.

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The term structure of interest rate

The term structure of interest rates, also known as the yield curve, is a very common bond valuation method. Constructed by graphing the yield to maturities and the respective maturity dates of benchmark fixed-income securities, the yield curve is a measure of the market's expectations of future interest rates given the current market conditions. Treasuries, issued by the federal government, are considered risk-free, and as such, their yields are often used as the benchmarks for fixed-income securities with the same maturities. The term structure of interest rates is graphed as though each coupon payment of a noncallable fixed-income security were a zero-coupon bond that “matures” on the coupon payment date. The exact shape of the curve can be different at any point in time. So if the normal yield curve changes shape, it tells investors that they may need to change their outlook on the economy.

There are three main patterns created by the term structure of interest rates:

1) Normal Yield Curve: As its name indicates, this is the yield curve shape that forms during normal market conditions, wherein investors generally believe that there will be no significant changes in the economy, such as in inflation rates, and that the economy will continue to grow at a normal rate. During such conditions, investors expect higher yields for fixed income instruments with long-term maturities that occur farther into the future. In other words, the market expects long-term fixed income securities to offer higher yields than short-term fixed income securities. This is a normal expectation of the market because short-term instruments generally hold less risk than long-term instruments; the farther into the future the bond's maturity, the more time and, therefore, uncertainty the bondholder faces before being paid back the principal. To invest in

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one instrument for a longer period of time, an investor needs to be compensated for undertaking the additional risk.

Remember that as general current interest rates increase, the price of a bond will decrease and its yield will increase.

2) Flat Yield Curve:

These curves indicate that the market environment is sending mixed signals to investors, who are interpreting interest rate movements in various ways. During such an environment, it is difficult for the market to determine whether interest rates will move significantly in either direction farther into the future. A flat yield curve usually occurs when the market is making a transition that emits different but simultaneous indications of what interest rates will do. In other words, there may be some signals that short-term interest rates will rise and other signals that long-term interest rates will fall. This condition will create a curve that is flatter than its normal positive slope. When the yield curve is flat, investors can maximize their risk/return tradeoff by choosing fixed-income securities with the least risk, or highest credit quality. In the rare instances wherein long-term interest rates decline, a flat curve can sometimes lead to an inverted curve.

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3) Inverted Yield Curve:

These yield curves are rare, and they form during extraordinary market conditions wherein the expectations of investors are completely the inverse of those demonstrated by the normal yield curve. In such abnormal market environments, bonds with maturity dates further into the future are expected to offer lower yields than bonds with shorter maturities. The inverted yield curve indicates that the market currently expects interest rates to decline as time moves farther into the future, which in turn means the market expects yields of long-term bonds to decline. Remember, also, that as interest rates decrease, bond prices increase and yields decline.

You may be wondering why investors would choose to purchase long-term fixed-income investments when there is an inverted yield curve, which indicates that investors expect to receive less compensation for taking on more risk. Some investors, however, interpret an inverted curve as an indication that the economy will soon experience a slowdown, which causes future interest rates to give even lower yields. Before a slowdown, it is better to lock money into long-term investments at present prevailing yields, because future yields will be even lower.

The Theoretical Spot Rate Curve:

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Unfortunately, the basic yield curve does not account for securities that have varying coupon rates. When the yield to maturity was calculated, we assumed that the coupons were reinvested at an interest rate equal to the coupon rate, therefore, the bond was priced at par as though prevailing interest rates were equal to the bond's coupon rate.

The spot-rate curve addresses this assumption and accounts for the fact that many Treasuries offer varying coupons and would therefore not accurately represent similar noncallable fixed-income securities. If for instance you compared a 10-year bond paying a 7% coupon with a 10-year Treasury bond that currently has a coupon of 4%, your comparison wouldn't mean much. Both of the bonds have the same term to maturity, but the 4% coupon of the Treasury bond would not be an appropriate benchmark for the bond paying 7%. The spot-rate curve, however, offers a more accurate measure as it adjusts the yield curve so it reflects any variations in the interest rate of the plotted benchmark. The interest rate taken from the plot is known as the spot rate.

The spot-rate curve is created by plotting the yields of zero-coupon Treasury bills and their corresponding maturities. The spot rate given by each zero-coupon security and the spot-rate curve are used together for determining the value of each zero-coupon component of a noncallable fixed-income security. Remember, in this case, that the term structure of interest rates is graphed as though each coupon payment of a noncallable fixed-income security were a zero-coupon bond.

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T-bills are issued by the government, but they do not have maturities greater than one year. As a result, the bootstrapping method is used to fill in interest rates for zero-coupon securities greater than one year. Bootstrapping is a complicated and involved process and will not be detailed in this section (to your relief!); however, it is important to remember that the bootstrapping method equates a T-bill's value to the value of all zero-coupon components that form the security.

The Credit Spread

The credit spread, or quality spread, is the additional yield an investor receives for acquiring a corporate bond instead of a similar federal instrument. As illustrated in the graph below, the spread is demonstrated as the yield curve of the corporate bond and is plotted with the term structure of interest rates. Remember that the term structure of interest rates is a gauge of the direction of interest rates and the general state of the economy. Corporate fixed-income securities have more risk of default than federal securities and, as a result, the prices of corporate securities are usually lower, while corporate bonds usually have a higher yield.

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When inflation rates are increasing (or the economy is contracting) the credit spread between corporate and Treasury securities widens. This is because investors must be offered additional compensation (in the form of a higher coupon rate) for acquiring the higher risk associated with corporate bonds.

When interest rates are declining (or the economy is expanding), the credit spread between Federal and corporate fixed-income securities generally narrows. The lower interest rates give companies an opportunity to borrow money at lower rates, which allows them to expand their operations and also their cash flows. When interest rates are declining, the economy is expanding in the long run, so the risk associated with investing in a long-term corporate bond is also generally lower.

Now you have a general understanding of the concepts and uses of the yield curve. The yield curve is graphed using government securities, which are used as benchmarks for fixed income investments. The yield curve, in conjunction with the credit spread, is used for pricing corporate bonds. Now that you have a better understanding of the relationship between interest rates, bond prices and yields, we are ready to examine the degree to which bond prices change with respect to a change in interest rates.

There are three basic theories that describe the term structure of interest rates and explain the shape of the yield curve.

1. Pure Expectations Theory:

The expectations hypothesis (also known as the unbiased expectations theory, or pure expectations theory) imagines a yield curve that reflects what bond investors expect to earn on successive investments in short-term bonds during the term to maturity of the long-term bond.

It suggests that the term structure of interest rates is based on investor expectations about future rates of inflation and

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corresponding future interest rates, assuming that the real interest rate is the same for all maturities.

According to the theory, forward rates exclusively represent expected future rates. Thus, the entire term structure at a given time reflects the market's current expectations of the family of future short-term rates.

Under this view, a rising term structure must indicate that increasing rates of inflation are expected, and the market expects short-term rates to rise throughout the relevant future. Similarly, a flat term structure reflects an expectation that future short-term rates will remain relatively constant, while a falling term structure must reflect an expectation of decreasing rates of inflation and that future short-term rates will decline steadily.

This theory suffers from one serious shortcoming: it says nothing about the risks inherent in investing in bonds and like instruments. If forward rates were perfect predictors of future interest rates, then the future prices of bonds would be known with certainty!

2. Liquidity Preference Hypothesis

According to the liquidity preference hypothesis (also known as the maturity premium theory), long-term bonds are more risky than short-term bonds because:

Long-term bonds are less liquid. Long-term bonds are more sensitive to changes in interest rates. The longer the maturity of a bond, the greater the price volatility

when interest rates change.

All else equal, rational investors will prefer the less risky, short-term bonds. Therefore, long-term bonds should always provide a maturity premium to compensate for the liquidity risk. Based on this theory, an upward sloping yield curve may be caused by one of the following two reasons:

1. Future interest rates will rise, or 2. Future interest rates will be unchanged or fall, but the maturity

premium will increase fast enough with maturity so as to cause the yield curve to slope upward.

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Flat or downward sloping yield curves are mainly caused by declining future short-term interest rates.

3. Market Segmentation Theory :

Both of the above theories assume that an investor holding bonds of one maturity can switch to holding bonds of another maturity. The market segmentation theory contends that shape of the yield curve is determined by supply of and demand for securities within each maturity sector. It believes that the yield curve mirrors the investment policies of institutional investors who have different maturity preferences.

Banks need liquidity and prefer to invest in short-term bonds, while corporations with seasonal fund needs prefer to issue short-term bonds.

Life insurance companies prefer to invest in long-term bonds to match their long-term liabilities, while real estate companies prefer to issue long-term bonds due to their long project cycles.

The bond market is segmented based on the maturity preferences of investors and issuers. Within each market segment, the prevailing yields are determined by the supply and demand for the bonds. An upward sloping yield curve indicates that:

Demand outstrips supply for short-term bonds, causing low short-term rates.

Supply outstrips demand for long-term bonds, resulting in high long-term rates.

If the yield curve is flat, that means both short-term and long-term bonds are in equilibrium so interest rates are the same for all maturities. You should be able to draw similar conclusions for other types of yield curves.

The Preferred Habitat Theory:

The Preferred Habitat Theory is a variant of the market segmentation theory. It also asserts that investors prefer to invest in particular maturity ranges. However, it argues that investors will shift out of their preferred maturity sectors if they are given a sufficient high maturity premium. In contrast, the market segmentation theory asserts that investors will always stick to their preferred maturity sectors.

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Determinants of Coupon Rate of Bond

Growth Rate of Economy

Growth rate of economy can be considered as one of the critical factor for determination of coupon rate of bond. High economy growth leads to high demand of funds may leads to high rate of coupon for bond and vice versa a healthy economic growth leads to high liquidity in the market.

Inflation

Inflation is rise in general level of prices of goods and services over time. Debtors may be helped by inflation due to reduction of the real value of debt burden. So the burden will be shifted to the investors. Low grade bonds are by definition subject to default risk; hence low grade investors will be primarily concerned with the risk of default. Deflationary episodes pose particular problems for low grade firms since there is a lack of pricing power in the broader macro economy. Hence, higher risk firms are particularly vulnerable to the economic environment within a deflationary environment. High grade bonds are alternatively the subject of a very low level of default risk. The primary concern for investors in high grade debt is the risk of inflation, since bonds generally perform poorly under inflationary conditions. When there is inflation, there is rising risk in the economy, so the credit spread has to widen to compensate the investors for the risk.

Tax Risk

If Bonds were originally issued with certain tax exemption features and subsequently there developed an uncertainty regarding their tax status in future, it could to lead to a price loss.

Liquidity risk

Liquidity risk is the risk that the lender might not be able to liquidate the debt on short notice. The difference in interest rate due to liquidity risk is

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called liquidity spread. Instruments such as bonds have active secondary markets. Other instruments such as savings deposits are easily transferable to cash. One the other hand 30-year US Government Savings Bond is nontransferable. It can only be redeemed at half price before maturity. The savings bond will obviously offer a higher return.

Another interesting phenomenon observed from liquidity spread is that on-the-run securities (primary market) have lower interest rates compare to the off-the-run securities (secondary market). This implies that there is a higher demand for on-the-run securities

Demand & Supply of Bond

According to demand & supply of bonds in the will decides the rate of coupon of bond. High demand of Bonds leads to lower coupon rate and vice versa.

When Demand for bond is high:

A change in wealth. As wealth increases, people will buy more bonds at each and every price, and the demand for bonds rises, or shifts right. So when an expanding economy increases both income and wealth, we expect bond demand to increase too.

A change in expected interest rates/returns. For bonds with more than a year to maturity, rising interest rates in the future will decrease the value of the bond (and hence the expected return). At each and every price, fewer bonds will be demanded. Bond demand will fall, or shift left when expected future interest rates fall. The size of the decrease will be larger for longer term bonds.

A change in expected inflation. If investors expect the inflation rate to rise, then they expect the real return on their bond to fall, as future payments are able to buy less. Higher inflation expectations decrease bond demand.

A change in the relative risk of bonds. At any given price or expected return, if bonds become riskier than other assets, people will switch to less risky assets. An increase in the relative risk of bonds with decrease bond demand.

A change in the relative liquidity of bonds. If it becomes harder to resell bonds in the bond market relative to other assets, people will switch to assets that are easier to resell. A decrease in the relative liquidity of bonds will decrease bond demand.

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When of Supply of bond is high

A change in business conditions. Firms issue bonds to finance the purchase of capital equipment and the expansion of production. This makes sense only if this expansion is expected to be profitable. As economic conditions become more favorable, expected profitability rises and bond supply will increase or shift right. Also tax incentives for borrowing can also be considered a business condition.

A change in expected inflation. While rising inflation decreases the real return for those who buy bonds, it decreases the real cost of borrowing for those who issue bonds: For a given nominal interest rate (and bond price), higher inflation means a lower real interest rate. Thus, higher expected inflation increases bond supply.

A change in government borrowing. If the government runs budget deficits, the U.S. Treasury must issue additional bonds to finance the shortfall in tax revenue. At each and every bond price, the quantity supplied increases.

The demand for bonds is the same as the supply of bond. Those who buy bonds are providing loans to others and are receiving interest.

The supply of bonds is the same as the demand for bond. Those who supply or issue bonds are borrowing money and paying interest.

Credit Risk

Ratings affect a bond's yield, or the percentage return investors can expect on the bond. A highly rated bond typically has a lower yield. That's because the issuer does not have to offer as high a coupon rate to attract investors. A lower rated bond typically has a higher yield. That's because investors need extra incentive to compensate for the higher risk. Generally, credit rating is the opinion of rating agencies on the degree of certainty of debt servicing of corporations, which takes account of both the default probability and the recovery rate.

However, this rating does not change in response to changes in the macro-economic conditions. Therefore, it is suggested that the credit rating would explain spreads, but only to a limited degree. The default rate for a particular rating for any given period is the number of defaults among the credits carrying that rating, as percentage of the total number of outstanding credits carrying that rating. Normally the Default rate rises as

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the rating changes from AAA to the lower category. The higher the probability of default higher is the risk in the bond which leads to increase in the spread. So theoretically we can say that; Default rate and Credit spread are positively related, default rate being one of the most important factors in determining Credit spread of the bond.

Tenure of Bond

Normally as the tenure of the bond increases, the risk also increases hence the credit spread should also increase. Research states that corporate rates are cointegrated with government rates and the relation between credit spreads and Treasury rates depends on the time horizon. In the short-run, an increase in Treasury rates causes’ credit spreads to narrow. This effect is reversed over the long-run and higher rates cause spreads to widen.

Risk free rate

In the Merton framework the risk free rate has an impact upon the value of the corporate bond for two reasons. First, an increase in the risk free rate implies that the price of the put option will decrease because the discounted present value of expected future cash flows will have decreased. The corporate bond investors experience a net increase in the value of their long corporate bond position. The price of the corporate bond increases and the spread over an equivalent risk-less bond tightens.

The second effect arises from the structural assumption that the firms’ risk-neutral growth path is a positive function of the risk free rate. As the risk free rate increases firm value increases, again lowering the price of a put option on the firm. The overall effect of an increase in the risk free rate is to decrease the effective costs of insurance against default on the firm’s debt. The price of a put option to protect against that default has fallen as the risk free rate has increased. Increases in the risk free rate reduce the price of the put option, implying that the corporate bond will increase in value, the corporate yield will fall and the spread over an equivalent risk free bond will tighten. Here we take the interest rate on central government securities, which is the weighted average of the central government

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securities with different maturities. Better results are expected by taking the corresponding value of the interest rate for different maturities and issuance time. But the result would be almost the same.

Foreign Exchange Rate (Forex)

The foreign exchange rate is an indirect factor which influences the credit spread. There is lot of funds flowing from the foreign countries in form of volatile FIIs. When the rupee is appreciated the foreign investment would be increased and if rupee is depreciated, funds will flow out. This is due to the fact that the appreciation of the rupee denotes the strengthening of the Indian economy so the funds flow in. In the regression analysis we have used percentage change in the dollar value of the rupee (Rs/$).

Interest Rate Risk Management

Interest rate risk management comprises the various policies, actions and

techniques that an institution can use to reduce the risk of diminution of its

net equity as a result of adverse changes in interest rates.

Various aspects of interest rate risk include the following:

1. Re-pricing risk: Variations in interest rates expose the institution‘s

income and the underlying value of its instruments to fluctuations.

This arises from timing differences in the maturity of fixed rates and

the re-pricing of the floating rates of the institution’s assets, liabilities

and off-balance sheet position

2. Yield Curve risk: This risk emanates from the changes in the slope and shape of the yield curve.

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3. Basis Risk (spread risk): Arises when assets and liabilities are priced off different yield curves and the spread between these curves shifts. When this yield curve spreads change, income and market values may be negatively affected. Such situations arise when an asset that is re-priced regularly (say) based on the inflation index is funded by a liability that is re-priced based (say) on the central bank accommodation rate

4. Optionality: Options may be embedded within otherwise standard instruments. The latter may include various types of bonds or notes with caller put provisions, non-maturity deposit instruments that give the depositor has the right to withdraw their money, or loans that borrowers may pre pay without penalty.

Framework for IRM

Broad principles to the foundation for interest rate risk management.

Board of Directors to approve strategies and policies for interest Rate Management.

Senior Management to take steps to monitor and control these risks.

Board to rate exposure in order to monitor and control the same.

Senior management should ensure that structure of the bank’s

business and the level of interest rate is effectively managed.

Appropriate policies and procedures are in place to control these

risks. Resources are available for evaluating and controlling this risk.

Banks should clearly define individuals or committees who are

responsible for managing risk.

Risk management function should be independent of position taking

function to avoid conflict of interest.

IRM policies and procedures are clearly defined and appropriate to

the level of complexity of the operations of the bank. These can be

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applied on a consistent base at the group level and as appropriate at

the level of the individual affiliates.

Banks must understand the risk in new products before they are

introduced and subject to adequate controls.

Major hedging or risk management strategies should be approved in

advance, by the Board or appropriate committee.

Banks should have interest rate risk measurement system that

captures all material sources of interest rate risk and that assess the

effect of interest rate changes in ways that are consistent with the

scope of their activities. The assumptions underlying the model

should be clearly understood by the risk managers.

Banks must establish and enforce operating limits and other

practices that maintain exposure within levels consistent internal

policies.

Banks must measure their vulnerability to loss under stressful

market conditions. This should include a breakdown of all underlying

assumptions. The result there from must be factored into the policies

and the limits determined.

Banks must have adequate information systems for measuring,

monitoring, controlling and reporting interest rate risk. Timely

reporting to senior management and board cannot be over

emphasized.

Banks must have adequate internal control systems including

independent review of the system. Supervisory authorities must

obtain from the bank adequate and timely reports with which to

evaluate the level of interest rate risk. The information must take the

range maturities and currencies in each bank’s portfolio. It must

include all off balance sheet items as well as other well other relevant

factors.

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Banks must hold capital commensurate with the level of interest rate

risk they run.

Banks must release to the public information on the level of interest

rate risk and the policies for its management.

Supervisory authorities should assess the internal measurement

system of banks adequately capture the interest risk in their banking

book. If there is inadequacy then the banks must bring up

their system.

Banks must furnish the results of their internal measurement

systems to the supervisory authority. If the supervisory authority

determines that the bank is not carrying capital commensurate with

the risk, it should direct that the bank either reduce the risk or

increase the capital.

Risk Associated with Investing in Bonds

Interest Rate Risk

The price of the bond will change in the opposite direction from the

change in interest rate. As interest rate rises the bond price

decreases and vice versa.

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If an investor has to sell a bond prior to the maturity date, it means

the realization of capital loss.

This risk depends on the type of the bond; callable puttable etc????

Reinvestment Income or Reinvestment Risk

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The additional income from such reinvestment called interest on

interest depends on the prevailing interest rate levels at the time of

reinvestment.

Call Risk

The issuer usually retains this right in order to have flexibility to

refinance the bond in the future is market interest rate drops below

the coupon rate

Disadvantage for investors for callable bond: cash flow pattern not

known with certainty, interest rate drop, and capital appreciation

will reduce.

Credit Risk

If the issuer of a bond will fail to satisfy the terms of the obligation

with respect to the timely payment of interest and repayment of

the amount borrowed.

Yield = market yield + risk associated with credit risk

Inflation Risk

Purchasing power risk arises because of the variation in the value of

cash flow from the security due to inflation.

Exchange Rate Risk

Risk associated with the currency value for non-rupee denominated

bonds. e.g.: US Treasury bond.

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Liquidity Risk

It depends on the size of the spread between bids and asks price

quoted. Wider the spread is risky.

For investors keeping till maturity, this is unimportant.

Market to market should be calculated portfolio value.

Volatility Risk

Value of bond will increase when expected interest rate volatility

increases.

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What is the difference between the bond market and the stock

market?

Many people think that the bond market and the stock market is one and

the same. In fact, many people who invest in bond market and the stock

market either with their own personal investment account or retirement

plans also cannot tell the difference between the two. Although, most

people have a general idea that stock market is associated with risk while

bonds offer relatively more safety.

Bond market versus stock market is a crucial differentiating factor as both

markets can earn you money but they are different in terms of the potential

risks and rewards. Let us try and understand the difference between the

bond market and the stock market.

When you buy a share of stock, you actually end up taking the ownership in

the company whose stock you are investing in. This means that you will

end up sharing the profits as well as the losses incurred by the company in

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the years to come. If a company’s revenue decreases, it would ultimately

affect the stock price of that company leading to a decline in the stock price.

However, if the company’s revenue increases, the stock price would go up

because the company is generating more profits.

Trading hours of bond markets vary from country to country. At the New

York Stock Exchange (NYSE), which is the largest centralized bond market,

trading hours are between 9.30 AM to 4.00 PM.

On the other hand, a bond does not allow you ownership in a company. If a

company wants to raise money without dividing itself, they can decide to

sell bonds instead of issuing stocks. So, when you buy a bond of a company,

you become more like a creditor than an owner in the company, and you

are paid back over the life of the bond. As a bondholder, you will earn a

return on your money, which is a fixed percentage, and this return is paid

annually. So, if a bond is for 10 years, you will get interest for each of those

10 years and then your principal amount (the amount you invested) is

returned to you at the time of expiration of the bond.

The bond market is where investors go to trade (buy and sell) debt

securities, prominently bonds. The stock market is a place where investors

go to trade (buy and sell) equity securities like common stocks and

derivatives (options, futures etc). Stocks are traded on stock exchanges. In

the United States, the prominent stock exchanges are: Nasdaq, Dow, S&P

500 and AMEX. These markets are regulated by the Securities Exchange

Commission (SEC).

The differences in the bond and stock market lie in the manner in which the

different products are sold and the risk involved in dealing with both

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markets. One major difference between both markets is that the stock

market has central places or exchanges (stock exchanges) where stocks are

bought and sold. However, the bond market does not have a central trading

place for bonds; rather bonds are sold mainly over-the-counter (OTC). The

other difference between the stock and bond market is the risk involved in

investing in both. Investing in bond market is usually less risky than

investing in a stock market because the bond market is not as volatile as

the stock market is.

Short term Treasury yields haven’t moved from the recessionary lows, but

the five and ten year bonds are back in recessionary ranges. The thirty year

hasn’t moved down as much in yields, but that could change quickly if

shorter maturities continue their downward trend as investors reach for

yield (or if deflation does, in fact, ensue).

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The stock market sees these low yields and argues that an upward sloping

curve is bullish for the economy. Also, arguments exist that investing in

dividend paying stocks is better than investing in poor yielding bonds. This

is true unless we see an economic slowdown or deflation. In either case,

equities will lose value.

In the short term, you have greater chances of losing money in the stock

market than the bond market. However, in order to figure out which is a

better investment opportunity, you should study your risk tolerance along

with the kind of returns you are looking for and according make the choice

of investing either in the bond market or the stock market.

BONDS ON NYSE

U.S. Government Bonds

These are bonds which are issued by the U.S. Treasury. They're grouped in three categories.

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

Treasury are widely regarded as the safest bond investments, because they are backed by "the full faith and credit" of the U.S. government. In other words, unless something apocalyptic occurs, you'll most certainly get paid back. Since bonds of longer maturity tend to have higher interest rates (coupons) because you're assuming more risk, a 30-year Treasury has more upside than a 90-day T-bill or a five-year note. But it also carries the potential for considerably more downside in terms of inflation and credit risk

Compared to other types of bonds, however, even that 30-year Treasury is considered safe. And there's another benefit to Treasury: The income you earn is exempt from state and local taxes.

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Municipal Bonds

Municipal bonds are a step up on the risk scale from Treasury, but they make up for it in tax trickery. Thanks to the U.S. Constitution, the federal government can't tax interest on state or local bonds (and vice versa). Better yet, a local government will often exempt its own citizens from taxes on its bonds, so that many municipals are safe from city, state and federal taxes. (This happy state of affairs is known as being triple tax-free.)

These breaks, of course, come at a cost: Because tax-free income is so enticing to high-income investors, triple tax-free municipals generally offer a lower coupon rate than equivalent taxable bonds. But depending on your tax rate, your net return may be higher than it would be on a regular bond.

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Corporate Bonds

Corporate bonds are generally the riskiest fixed-income securities of all because companies -- even large, stable ones -- are much more susceptible than governments to economic problems, mismanagement and competition.

That said, corporate bonds can also be the most lucrative fixed-income investment, since you are generally rewarded for the extra risk you're taking. The lower the company's credit quality, the higher the interest you're paid. Corporates come in several maturities:

Short term: one to five years Intermediate term: five to 15 years Long term: longer than 15 years

The credit quality of companies and governments is closely monitored by two major debt-rating agencies: Standard & Poor's and Moody's. They assign credit ratings based on the entity's perceived ability to pay its debts over time. Those ratings -- expressed as letters (Aaa, Aa, A, etc.) -- help determine the interest rate that company or government has to pay.

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Corporations, of course, do everything they can to keep their credit ratings high -- the difference between an A rating and a Baa rating can mean millions of dollars in extra interest paid. But even companies with less-than-investment-grade (Ba and below) ratings issue bonds. These securities, known as high-yield, or "junk," bonds, are generally too speculative for the average investor, but they can provide spectacular returns.

Apart from the above mentioned bonds there are various other bonds such as

Federal Agency Bonds

In addition to the U.S. Treasury and local municipalities, other government agencies (usually at the federal level) issue bonds to finance their activities. These agency bonds help support projects relevant to public policy, such as farming, small business, or loans to first-time home buyers. Agency bonds are no small matter, however -- according to the Bond Market Association, agency bonds worth $845 billion are now outstanding in the market. These bonds do not carry the full-faith-and-credit guarantee of government-issued bonds (for example U.S. Treasuries), but investors are likely to hold them in high regard because they have been issued by a government

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agency. That translates into more favourable interest rates for the agency, and the opportunity to support sectors of the economy that might not otherwise be able to find affordable sources of funding.

Among the federal agencies that issue bonds are:

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 Student Loan Marketing Association (Sallie Mae) College Construction Loan Insurance Association (Connie Lee) Small Business Administration (SBA) Tennessee Valley Authority (TVA)

While most investors in federal agency securities are institutional, individuals can also invest in this segment of the debt securities market.

Revenue Bonds

A municipal debt on which the payment of interest and principal depends on revenues from the particular asset that the bond issue is used to finance. Examples of such projects are toll roads and bridges, housing developments, and airport expansions. Revenue bonds are generally considered of lower quality than general obligation bonds, but there is a great amount of variance in risk depending on the particular assets financed.

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Equity Index Notes

Equity Index-Linked Notes pay a variable returned based upon the performance of an equity market index, such as the Standard & Poors 500 Composite Price Index of U.S. stocks, measured from a predetermined level.

These notes are issued so that a conservative investor may participate in equity market returns while at the same time ensuring that principal will be repaid at maturity regardless of the equity market's performance. This feature eliminates the risk of losing principal that is inherent in traditional stock and mutual fund investments.

These notes usually have a maturity of anywhere between two-and-eight years. Typical notes allow an investor the choice of (i) holding the note to maturity and receiving any variable return at maturity, (ii) selling the note in the secondary market prior to maturity, or (iii) electing to receive early payment of variable return prior to maturity based on any index performance up to the time of election and receiving the principal amount at maturity.

Sovereign Bonds

A sovereign bond is a bond issued by a national government. The term usually refers to bonds issued in foreign currencies, while bonds issued by national governments in the country's own currency are referred to as government bonds. The total amount owed to the holders of the sovereign bonds is called sovereign debt.

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