Fixed Investment

Management

Atif Raza Akbar (B17012)

Fixed Investment Management Atif Raza Akbar (B17012)

Case background

Fixed Investment Management is firm which manages the investment

portfolios of their clients and provides them with recommendations in order to
maximize their income from invested funds. Robert supervises a team of analysts at
Fixed Investment Group who are tasked with looking out for attractive bonds and
investment opportunities for their clients. We come face to face with two clients for
Fixed Investment Management Group, namely the Amboli Golf Club (currently
investing Rs 50 crore) and Mr. Rajdeep whose portfolio of Rs 4 crores is managed
by Robert and his analysts.
The board of trustees of the AGC endowment provided FIM with some
medium term goals, and then FIM would get back to AGC with some bonds that
would meet the stated criteria and then the trustees would convene to decide which
bond or bonds to buy. Generally, the trustees of AGC managed the endowment with
great caution and their major emphasis was on preservation of principal. However,
after the RBI cut down on the interest rate of GOI bonds to 6.549% from 7.783%,
the trustees wanted to take a more aggressive stance. Still, they wanted to play safe
and invest in safe bonds with high yields. To provide Amboli Golf Club group with
investment decisions, Fixed Investment Management group had identified 4 bonds
for them to invest in by evaluating various aspects like the duration, yield to
maturity, convexity, risk to interest rates etc. These bonds were namely GOI
Treasury bonds, bonds offered by State Bank of India, bonds offered by D S
Kulkarni Developers Limited and Andhra Pradesh State Financial Corporation
bonds.
At the time of the writing of the case, Fixed Investment Management Group
were suddenly visited by Mr. Rajdeep who had brought with him an investment of
Rs 20 crores and wanted to invest in the sum immediately within next few hours.
Robert has a reputation to manage as an investment group that specializes in giving
out fast and reliable advice and hence is wondering which of the four above options
to offer as a suggestion to Mr. Rajdeep.
Fixed Investment Management Atif Raza Akbar (B17012)

Critical Considerations in the case

In order to evaluate the attractiveness of the bonds in question, Fixed Investment

Management Group must take the following into consideration -

1. What is the yield to maturity of the bonds in question?

The yield to maturity is the theoretical internal rate of return (IRR)

earned by an investor who buys the bond today at the market price, assuming
that the bond will be held until maturity, and that all coupon and principal
payments will be made on schedule. Yield to maturity is the discount rate at
which the sum of all future cash flows from the bond (coupons and principal)
is equal to the current price of the bond.

Yield is an important criterion for someone who is willing to invest a

large sum of money and expecting a decent return. In this case, Fixed
Investment Management Group needs to assess the yields to maturity of each
of the bonds before passing on any recommendation to the clients.

2. How long do each of the bonds take before they start paying back the
investments – their Macaulay durations?

Macaulay duration gives the approximate weighted average of the

number of years an investor must maintain his investment in the bond in order
for the present value of bond become equal to the price paid for the bond.
Hence, Macaulay’s duration will give the approximate idea on when can a
person start to expect the returns associated with the bonds.

A bond's price, maturity, coupon and yield to maturity all factor into
the calculation of duration. All else equal, as maturity increases, duration
increases. As a bond's coupon increases, its duration decreases. As interest
rates increase, duration decreases and the bond's sensitivity to further interest
rate increases goes down. Fixed Investment Management Group would want
to calculate the values of Macaulay’s duration in order to estimate the
attractiveness of the bonds they suggest to their client.
Fixed Investment Management Atif Raza Akbar (B17012)

3. How volatile are the bond options to the market conditions? What are
their convexities?

Duration is a measure of bond price sensitivity to interest rate

movements and other market conditions. While not a perfect relationship in
practice, a good rule of thumb is that a 1% move in yields leads to a gain or
loss equal to the amount of duration on a bond or bond fund. The longer the
duration, higher is the sensitivity of a bond. Bonds with a lower coupon rate
are affected more in a market. Slight changes in the interest rates in the market
also affect the valuation of a bond.

The convexity of a bond measures sensitivity of a bond measures the

relationship between the price of the bond and yield offered by the bond with
respect to the changing interest rate on a particular bond. The study of
convexity helps us understand how an increase or decrease of 1% interest in
the market is going to affect the yield offered by the bond. When ascertaining
convexity, the graph obtained is generally curve in nature as the effect on
interest rate changes, the yield of bond is ascertained to be inversely
proportional to the price of the bond, but the same is not linearly dependent to
the other one.

4. How does one analyze the ratings of the bonds in question? Are they an
important factor?

Ratings of different kinds of bonds allow a bond to be categorized as

investment grade bond or a non-investment grade (‘junk’ bonds). The benefits
of investment grade bonds are that they are considered to be considerably safer
but provide a relatively lower yield and are recommended to investors that are
looking to carry out a lower risk investment. Non-investment or ‘junk’ bonds
are those type of bonds that provide a relatively higher return than investment
grade bonds but they are also associated with higher risks. These type of bonds
are recommended to investors who is looking for higher returns for a given
investment.

Robert must make sure he offers appropriate bonds taking into account
the risk-taking capabilities of the clients in question.
Fixed Investment Management Atif Raza Akbar (B17012)

Analysis and Interpretations

Yield to maturity
Yield to maturity is the calculation of a bond’s yield. It can also be considered as
the Internal Rate of Return of an investment.
𝐶 𝐶 𝑃+𝐶
Present value of the bond (for 5 years’ duration) = + +……….+
(1+𝑦) (1+𝑦)^2 (1+𝑦)^5

where,
Y= yield to maturity
C= coupon payment
P= principal
A bond that is priced above its face value sells at a premium. Yield to
maturity of these bonds always less than the current yield. A bond that is priced
below its face value sells at a discount. Investors of a discount bond face capital
gain over the life of the bond. So, the yield to maturity of a discount bond is greater
than the current yield.
Using the above formula, we were able to calculate yields to maturity as
follows
DS Andhra
GOI Kulkarni Pradesh State
Treasury State Bank Developers Financial
Particulars Bond of India Limited Corporation
Coupon 8.08% 10.1% 12.75% 9.15%
Coupon Payment Yearly Yearly Quarterly Semi Annually
Last Traded Price
(%) 105.55 101.48 73.50 49.15
Yield 6.76% 9.70% 5.38% 14.52%

Macaulay’s Duration
To estimate Macaulay’s duration, the sum of present values of periodic cash flows
was divided by the face value of the bonds to calculate the expected duration after
which the bond will return the investment.
Fixed Investment Management Atif Raza Akbar (B17012)

𝐶 × 𝑛1 𝐶 × 𝑛2 (𝐶 + 𝑃) × 𝑛5
𝑃𝑉 = + + ⋯
1+𝑖 (1 + 𝑖)2 (1 + 𝑖)5

𝑃𝑉
𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 ′ 𝑠 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
𝐹

Where,

PV = Sum of present values of all the cashflows

C = Cash flow for the particular period
ni = period of cash flow
i = discount rate (GOI rates)
F = Face value of the bond.

We assume the GOI rates at 6.459%.

The Macaulay’s Duration carried out using the above formula is found out to be as
following:
DS Andhra
GOI
State bank Kulkarni Pradesh State
Treasury
of India Developers Financial
bonds
Ltd Corporation
Macaulay’s
Duration (in 4.60 4.85 4.99 4.65
years)

Volatility

Volatility of bonds depend upon the Macaulay’s duration of bonds i.e. the no. of
years after which the bonds are expected to provide returns and the yield to maturity
of bonds.
𝑀
𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑏𝑜𝑛𝑑𝑠 =
1+𝑦

Where,
M = Macaulay’s duration
Y = Yield to maturity of the bonds.
Fixed Investment Management Atif Raza Akbar (B17012)

The result of volatility of bonds are found to be as below:

DS Andhra
GOI
State bank Kulkarni Pradesh State
Treasury
of India Developers Financial
bonds
Ltd Corporation
Volatility of 4.31 4.42 4.74 4.06
bonds

Credit ratings
Based on the credit rating, bonds are classified as investment grade bonds and
non-investment grade or ‘junk bonds’.
DS Andhra
GOI
State bank Kulkarni Pradesh State
Treasury
of India Developers Financial
bonds
Ltd Corporation
Credit rating AAA AAA BBB+ BB+

From the above table, we can imply that GOI treasury bonds and State Bank
of India bonds are the safest bonds and are likely to repay the investors. The
investment in D S Kulkarni Developers Limited is relatively riskier than that in
government securities, while the bonds of Andhra Pradesh State Financial
Corporation is still an investment grade bond but is the lowest in the spectrum.
Assimilated results
DS Andhra
GOI Kulkarni Pradesh State
Treasury State Bank Developers Financial
Particulars Bond of India Limited Corporation
Yield 6.76% 9.70% 5.38% 14.52%
Macaulay’s
Duration (in 4.60 4.85 4.99 4.65
years)
Volatility of 4.31 4.42 4.74 4.06
bonds
Credit rating AAA AAA BBB+ BB+
Fixed Investment Management Atif Raza Akbar (B17012)

Recommendations
On the basis of the assimilated results, Robert is well-positioned to give
recommendations to his clients.
1. Faced with Mr. Rajdeep first, he would be advised to offer the Andhra
Pradesh State Financial Corporation bonds to him as they have the highest
yield rates of all the bonds. This is in spite of the bonds having the lowest
credit ratings of all the bonds, because Mr. Rajdeep’s risk capacity is not
known. Apart from the credit rating which is still investment-grade, the
APSFC bonds perform well in all other criteria. The APSFC bonds have
lowest volatility, and very short Macaulay durations, second only to the GOI
treasury bonds.

2. To the Amboli Golf Club group, Robert can suggest either the APSFC bonds
or the SBI bonds depending upon whether they are willing to trade yield for
a better credit rating. We know that they are still looking for ‘safe bonds
with high yields’ which is an oxymoron in itself. But we also know that they
are adopting a more aggressive stance, hence, it may be assumed that they
can be persuaded to go for the APSFC bonds as they outperform every other
bond in most criteria apart from credit ratings.