Deterministic Cash

Flow Streams
UNIT 7 FIXED INCOME SECURITIES
Structure
7.0 Objectives
7.1 Introduction
7.2 Fixed Income Securities: Corporate Securities
7.2.1 Types of Bonds and Debentures
7.2.2 Preference Shares
7.3 Other Fixed-Income Securities
7.3.1 Fixed Deposits
7.3.2 Treasury Bonds or Government Securities
7.3.3 Municipal Bonds
7.3.4 Tax Free Bonds
7.4 Bond Yields
7.4.1 Current Yield
7.4.2 Yield to Maturity
7.4.3 Relationship Between Yield to Maturity and Coupon Rate
7.4.4 Yield to Call
7.4.5 Holding Period Return
7.5 Valuation of Bonds
7.5.1 Annual Versus Semi-Annual Interest
7.5.2 Interaction Between Coupon Rate, Required Rate of Return and
Bond Value
7.5.3 Time to Maturity and Valuation of Bond
7.6 Risks in Bonds
7.7 Let Us Sum Up
7.8 Answers/Hints to Check Your Progress Exercises

7.0 OBJECTIVES
After studying this Unit, you should be able to:
• describe the features of fixed income securities;
• list the types of corporate and other securities in which investors desirous of
regular and assured return can invest;
• explain the ideas of Basic Yield, Yield to Maturity, Yield to Call etc. and
their role in investment decisions;
• distinguish between (i) annual and semi-annual interest rate and required rate
vis-a-vis the coupon rate; (ii) time to maturity and resultant valuation ; and
• discuss the sources of risk in fixed-income securities.


Dr. Prachi Bagla, Associate Professor, Maitreyi College, University of Delhi
138
 Fixed Income
7.1 INTRODUCTION Securities

In the previous unit, you learnt about time value of money, interest rates, internal
rate of return, etc. The aim of that unit was to give you some tools to understand
how returns on financial instruments work, specially those where a stream of
returns accrue. You also learnt about basics of investing (say in a bank account to
park your savings, or in capital asset). In this unit, you will learn about the
features and qualities of various types of fixed-income financial securities. Two
major types of securities available in the capital market are:
1) Fixed income or fixed cost securities like debentures and government
securities; and
2) Variable income or variable cost securities like equity shares.

7.2 FIXED INCOME SECURITIES: CORPORATE

SECURITIES
Fixed income securities offer a fixed cash flow stream to the investor in the form
of regular interest payments and repayment at the time of maturity. Though all
types of investments involve risk, fixed income securities are relatively risk free.
Conservative investors, who are usually risk averse, interested in regular income
from their investments prefer to invest in them.

Features: From the corporate world, there are two types of fixed income/cost
securities:
• Bonds and debentures, also called debt instruments; and
• Preference shares.
The main features of bonds and debentures are:
1) Bonds and debentures are also called as creditor-ship securities. Its holders,
are called debt holders, and are creditors of the firm. Holders of these
securities do not enjoy voting rights in the firm. Thus, they do not participate
in the decision making process.
2) Debt holders are paid interest at a coupon rate (also called nominal rate). This
rate is fixed under an agreement as per the debt instrument and is calculated
on the face value of the security. An exception to this is the zero coupon
bonds on which no periodical interest is paid to the holder.
3) Bonds and debentures have a face value and a redemption value both of
which are specified on the face of the instrument. These two may be same or
different. If the debentures are convertible debentures, the bond may be
redeemed by conversion into equity shares.

139
Deterministic Cash 4) At the time of liquidation of the firm, debt holders get their repayment prior
Flow Streams
to equity shareholders and other unsecured creditors including preference
shareholders.

7.2.1 Types of Bonds and Debentures

As we noted above, bonds and debentures are two of the three types of corporate
securities (the other one being preference shares). Of these three, bonds and
debentures represent the most important type of fixed income securities serving
as investment vehicles for persons dependent on fixed regular income. Let us
first note the various types of debentures. There are three types of debentures
classified as follows:
1) Secured and Unsecured Debentures: Secured debentures are linked to the
assets of the company. This means, in case of default by the company, these
assets can be used to pay off the dues or debts. Unsecured debentures do not
have any such link over the assets of the company. They are issued on the
strength of general credit worthiness of the issuer.
2) Convertible and Non Convertible Debentures: A convertible debenture is one
that is converted into the equity shares of the issuing company. The
conversion is done on or before the maturity date and it is done as per the
terms of issue.
These debentures may be either compulsorily convertible or optionally
convertible. In case of optionally convertible debentures, the holder has the
option to exercise the option, if considered worthwhile, or to continue the
investment in the form of debentures itself. In case of compulsorily
convertible debentures, the investor has no such choice.
Besides, the convertible debentures may be fully or partially convertible. In
case of partially convertible debentures, a part of the face value is converted
into equity shares. The rest of the investment remains in the form of
debentures.
Convertible debentures are considered a more attractive form of investment.
Usually, firms offer a lower nominal rate of interest as compared to the non
convertible debentures.
3) Redeemable and Irredeemable Debentures: Almost all debentures are
redeemable with a fixed period of maturity. This period is mentioned on the
face of the instrument. Irredeemable, also called perpetual debentures, are
issued without any maturity date. Investors will keep receiving the periodical
interest throughout i.e. perpetually as long as the issuing company is alive.
Let us now turn to bonds. There are five types of bonds as outlined below.
a) Zero Coupon Fully Convertible Bonds: These bonds do not carry any
fixed rate of interest. They are fully and compulsorily convertible on a
specified date form the date of issue. Till conversion, no interest is paid to
the debenture holders. Such issues require credit rating by an approved
140 credit rating agency.
 Fixed Income
b) Deep Discount Bonds: It is a variant of zero coupon bonds. In this, there Securities
is an issue price, a maturity period and a maturity amount pre-specified.
There is no coupon rate of interest and no interest is payable during the
tenure of the bond. An enlightened investor will calculate the implicit rate
of interest, compare it with the return available on other investment
avenues, and will invest if the rate of return on such bonds is at least
equal to other securities as per his consideration.
c) Callable Bonds: In case of callable bonds, the company reserves the right
to retire the bond at any time after a stipulated period. The investor will
have to accept the redemption value when company decides to retire it.
Company may exercise this option if it has excess capital at any stage or
if the rate of interest in the market has fallen and cheaper funds are
available.
d) Putable Bonds: In case of putable bonds, the holder has an option to
redeem the bonds with the company any time after an initial lock-in
period. The investor may exercise this right if the coupon rate being
offered by the company has fallen lower than the market rate. The bond
holder will redeem the bond with the company and may reinvest his
money at higher rate of interest.
e) Floating Rate Bonds: As against the common connotation of fixed
income securities, the coupon rate in case of floating rate bonds is not
fixed. It is tied to some other interest rate called a benchmark. The rate at
which the company will pay interest will vary with variation in this
benchmark. Such bonds are not popular in India.
7.2.2 Preference Shares
In case of preference shares, dividend is payable at a fixed rate as appropriation
of profits. However, the company may not pay preference dividend if it does not
have divisible profits or enough liquidity. Investors, on the other hand, expect
dividends and there are adverse implications if this dividend is not paid. The
reputation of the company will be affected and it may not be able to raise capital
in future. Besides the preference, shareholders under this acquire voting rights at
par with the equity shareholders. This will be as per the provisions of the
Companies Act. As a result of this, control over the firm may get diluted.

7.3 OTHER FIXED INCOME SECURITIES

Now let us consider some other types of fixed income securities.
7.3.1 Fixed Deposits
These are the most widely used and considered the safest for fixed returns. These
can be fixed deposit with commercial banks or post offices. The investor deposits
a certain sum of money for a defined period and earns interest payable
periodically or on maturity as per the need and requirement of the depositor. 141
Deterministic Cash There are many variants of fixed deposit (also called term deposit) like recurring
Flow Streams
deposit (RD), flexi RD, etc. The deposit must be maintained for a pre decided
length of time (for example one year). There may be penalty for early
withdrawal. Most banks give an option of auto renewals for the deposit on
maturity.

7.3.2 Treasury Bonds or Government Securities

These are also called sovereign bonds. Treasury bonds are issued by the
government of a country. These may involve a periodic payment of interest at a
defined rate with repayment on maturity. Or, it may be in the form of zero
coupon bonds or as deep discount bonds. The proceeds are usually used by the
Government to finance its developmental projects. These are risk free bonds as
the governments do not default in meeting the commitments.

7.3.3 Municipal Bonds

These bonds are issued by the local government bodies like municipal
corporations. They are issued to finance projects like construction of roads,
bridges, schools, hospitals, etc. In India these were initiated in 1997 for the first
time. These bonds were not very popular with the investors to begin with. SEBI
issued guidelines in 2015 with respect to these bonds.

7.3.4 Tax Free Bonds

These bonds are issued by Government, its departments or entities owned by it
(like NTPC, Power Finance Corporation etc.). Interest proceeds are exempt from
income tax and, thus, provide an attractive investment avenue for investors
falling in high income bracket. These bonds have long term maturity up to 20
years and bear very low or almost zero risk of default.

Check Your Progress 1

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What are the important features of fixed income securities?
………………………………………………………………………………….
………………………………………………………………………………….
2) What is the difference between secured and unsecured bonds?
………………………………………………………………………………….
………………………………………………………………………………….
3) What is an important feature of convertible bonds.
………………………………………………………………………………….
………………………………………………………………………………….
142
 Fixed Income
4) What are callable bonds? How are they different from putable bonds?. Securities
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….

7.4 BOND YIELDS

Bond yield refers to the percentage return which an investor realises on his
investment in a bond. It may be different from the market rate of interest or the
required rate of return. Yield provides the actual return from bond and helps in
making a rational decision. Yields are always expressed on annual basis.
Various types of yields that are useful in investment process are as follows:
7.4.1 Current Yield
This is also called basic yield. It is calculated by dividing the annual interest
(through coupon rate) by the current market price of the bond.
Formula: Current yield = Interest/BO × 100
where BO = current market price of bond.
Current yield changes with change in the market price of the bond. The
illustration below shows that as market price increases yield decreases and
vice versa.
Illustration 1
Mr. A purchased a bond offering 10% return on the face value of Rs 100 for Rs
90 from the market. What is its current yield? If it is purchased at Rs 120, what
will be its current yield?
By looking at the market price and the par value, one can conclude about the
current yield viz-a-viz the coupon rate.
a) If bond is selling at a discount, current yield will be more than the coupon
rate.
b) If the bond is selling at a premium, current yield will be less than the coupon
rate.
c) If market price is equal to par value, current yield and the coupon rate will be
the same.
7.4.2 Yield to Maturity (YTM)
YTM is defined as the rate of return that will be earned if a bond is purchased at
the current market price and held till the maturity. To find the YTM, two
methods can be used:
143
Deterministic Cash a) A trial and error method: In this, we find out the rate of discount that
Flow Streams
equates the present value of cash flows (interest) and the current market
price. It may require interpolation to arrive at the accurate YTM.
b) Short cut method: This gives the approximate YTM.
YTM through trial and error method:
Symbolically:
n
int RV
BO =  +
i =1 (1 + YTM ) (1 + YTM )n
i

where Bo = current market price of the bond

RV = redemption value
n = maturity period of a bond
If interest is paid half yearly, the equation is:
2n int
RV
BO =  2 +
 YTM   YTM 
2n
i =1
1 +  1 + 
 2   2 

Using present value table, YTM is:

Annual: B0 = Interest × PVAF (YTM, n) + RV × PVF(YTM, n)

Semi annual: B0 = Interest/2 × PVAF (YTM/2, 2n) + RV × PVF (YTM/2, 2n)

Interpolation is done with the following formula:
𝐴
𝑌𝑇𝑀 = 𝐿 + × (𝐻 − 𝐿)
𝐴−𝐵
where L is the lower rate, H is the higher rate, A is NPV at the lower rate, B is
NPV at the higher rate
Another formula for interpolation, for an approximate value, is as below:
Int + (RV − B0 ) / n
Approximate YTM =
(RV + B0 ) / 2
where the symbols used has the same meaning as already introduced above. Let
us now take an illustration to understand the application of these below.
Illustration 2
The following information is available in respect of a bond:
Market value = Rs 900
Face value = Rs 1100
Coupon rate = 10%
Time to maturity = 6 years
144 Find out the YTM
 Fixed Income
Bo = Interest × PVAF (r,n) + Redemption Value × PVF (r,n) Securities
At 11%
Value = 110 × PVAF (.11,6) + 1100 × PVF (.11 , 6)
(110 × 4.231) + (1100 × 0.535)
465.41 + 588.5
Rs 1053.91
NPV = 1053.91 – 900 = 153.91
Value is higher than 900, we will try a higher rate.
Try 14%
Value = 110 × PVAF (.14, 6) + 1100 × PVF(.14, 6)
(110 × 3.889) + (1100 × 0.456)
427.79 + 501.6
Rs 929.39
Net present value = 929.39 – 900
= Rs 29.39
Value is still higher than Rs 900, we try another higher rate.
Try 16%
Value = 110 × PVAF (.16, 6) + 1100 × PVF (..16, 6)
110 × 3.685 + 1100 × 0.410
405.35 + 451
Rs 856.35
NPV = 856.35 – 900
Rs –43.65
YTM lies between 14 and 15 %
Using interpolation:
YTM and Investment Decision: While deciding to buy the bond or not the
investor can compare the YTM and his/her required rate of return and take the
decision as follows:
YTM > required rate Buy the bond
YTM < required rate Do not buy
YYM = required rate Indifferent: may or may not
buy
The required rate of return will be different for different investors and hence their
decisions will be different. 145
Deterministic Cash Illustration 3
Flow Streams
A bond having face value of Rs 1000 is available in the market for Rs 850. It has
a coupon rate of 8% and maturity period is 6 years. Compute YTM of the bond.
If the required rate of return of the investor is 10%, should he purchase the bond?
Use approximate method to find YTM.
The investor should buy the bond as YTM (11.54%) is > the required rate of
return (10%).
Illustration 4
Indicate whether the investor should buy the bond or not in the following
situations:
YTM (%) Required rate (%) Decision Reason
11 14 Do not buy YTM < required rate
Hence YTM is not meeting the
expectation
15 15 Indifferent YTM = required rate i.e.
YTM is exactly the same as
required rate
9 06 Buy YTM > required rate

7.4.3 Relationship between Yield to Maturity and Coupon Rate

If the Market price = par value, then YTM = coupon rate.
If the Market price > par value , then YTM < par value.
If the Market price < par value, then YTM > coupon rate.

7.4.4 Yield to Call (YTC)

For callable bonds, the maturity period (n) is not relevant as the company may
retire it before maturity. Hence, in case of callable bonds, need to calculate YTM
does not arise. For such bonds, YTC is calculated for the period up to the date
the bond can first be called and redeemed.
For example, a bond has a maturity of 10 years but the bond can be retired any
time after 30th June, 2021. Mr. A purchased this bond on 1st July 2018. The
company can exercise this option on 1st July 2021. So YTC i.e. yield to call will
be calculated for 3 years.
YTC is calculated the same way as YTM is calculated by trial and error method
with interpolation or through the short cut method. The period, however, will be
up to the date on which the call can first be exercised.

146
7.4.5 Holding Period Return (HPR) Fixed Income
Securities
An investor may not hold bond till the maturity and offload it anytime for a
variety of reasons. YTM will not be relevant for such investors since (i) his
holding period is less than the total maturity period and (ii) YTM does not
consider the market value before maturity. The investor would be interested in
knowing the return over his actual holding period. For holding period return, the
interest and capital gain (or loss) will be expressed as a percentage of the
purchase price as:
Total int income + (Bs − B0 )
HPR =  100
B0

where Bs is the sale price of bond

Bo is the purchase price
Illustration 5
An investor purchases a Rs 1500 par value bond with a coupon rate of 12% at Rs
1200. The investor keeps it for one year and sells it for a price of Rs 1400 after
receiving the interest. Calculate his HPR. Suppose in this question, the investor
retains the bond for 2 years. Find the HPR assuming that interest income can be
reinvested at an interest rate of 10%
Interest received in 1st year can be reinvested at the rate 10%.
It becomes 180 + (1.10) = Rs 198
Interest in the second year = Rs 180
Total interest = 198+180 = Rs 378
Purchase price = Rs 1200
Selling price = Rs 1400

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Define bond yield. What is the bond yield, vis-à-vis the coupon rate, that is
expected if the bond is selling at a premium?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) How do you define yield to maturity (YTM)? How is it different from yield
to call (YTC) and holding period return (HPR)?
………………………………………………………………………………….
………………………………………………………………………………….
147
Deterministic Cash 3) How is holding period return calculated?
Flow Streams
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
4) State whether True or False:.
a) If YTM is more than the required rate, the investor will not buy the bond.
b) YTC is calculated for the period up to the date when bond can first be
called by the issuing company.
c) If bond is selling at a discount, current yield will be more than the coupon
rate.

7.5 VALUATION OF BONDS

Valuation refers to the real worth of the financial asset. It represents its intrinsic
value. In this context, some important concepts of valuation are as follows:
1) Book Value: Book value of an asset can be found from the balance sheet of
the firm. For example, book value of debenture is the face value stated in the
balance sheet. For book value of equity share, net worth is divided by the
number of equity shares outstanding.
2) Market Value: This refers to the price for which the asset is traded. For
listed securities, market value is available from the stock exchange quotes.
For unlisted securities, market value is not so readily available.
3) Liquidating Value: This is the difference between the realisable value of the
assets less the total value of external liabilities.
4) Capitalised Value: This is the most realistic concept of valuation. It is
arrived at by considering the cash flows that the assets are capable of
generating. It is the sum of present value of the cash flows generated by the
security. It requires to be applied a discount rate which is the minimum
required rate of return of the investors. This rate depends on the risk tolerance
of the investor and the premium for the risk. This rate therefore varies from
investor to investor. It is the rate that will prompt the investor to acquire the
security.
Valuation of bonds is relatively simple when its cash flows are certain and when
they are in the annuity form. The latter is because of (i) fixed rate of interest on
the annuities and (ii) the price of the bonds does not fluctuate too widely.
The valuation model of the bond is:
𝑛
𝐼𝑛𝑡 𝑅𝑉
𝐵0 = ∑ +
1 + 𝑘𝑖 (1 + 𝐾)𝑛
𝑐=1

148
In the intrinsic value of a bond, there are two parts (i) present value of stream of Fixed Income
Securities
interest and (ii) present value of the redemption value received at maturity. Note
that:
• Interest is calculated at the coupon rate on the face value of the bond;
• Discounting is to be done at the required rate of return of the investor;
• Higher the required rate of return (or discount rate), lower is the value of the
bond and vice versa. Hence, there is an inverse relationship between bond
value and the required rate of return;
• Interest may be paid annually, half yearly or quarterly, etc.; and
• After intrinsic value is calculated, it is compared with the prevailing market
price to decide whether to buy or not. To be specific therefore, note the
following:

Intrinsic value > current market value Buy the bond as it is underpriced
Intrinsic value < current market price Do not buy the bond as it is over priced
Intrinsic value = current market price Indifferent
Illustration 6
A bond has a face value of Rs 2000, coupon rate is 10% and 5 years are left to
maturity. Find out the value of the bond if the investor’s expected rate of return is
12%.
Bo = Interest × PVAF (r,n) + RV × PVF (r,n)
200 × PVAF (.12,5) + 2000 × PVF (.12,5)
(200 × 3.605) + (2000 × 0.567)
721 + 1134
Rs 1855
Illustration 7
Mr. X is planning to purchase a bond having current price of Rs 925. The bond
has a par value of Rs 1000, with coupon rate of 10% and 4 years to maturity.
Should he buy the bond if his required rate of return is 12%?
Bond price if his required rate of return is 12% is to be calculated by the formula:
100 × PVAF (r,n) + 1000 × PVF (r.n)
100 × PVAF (.12,4) + 1000 × PVF (.12,4)
(100 × 3.037) + (1000 × 0.636)
303.70 + 636
= Rs 939.70
The investor should buy as the intrinsic value (worth of the bond for him) is more
than the price in the market.
149
Deterministic Cash 7.5.1 Annual Versus Semi Annual Interest
Flow Streams
Given a choice between annual and semi annual interest, what should be the
decision of the investor? The following clues should be used by an investor:
If the required rate of return is > the coupon rate then:
Bond value in case of annual interest should be > the bond value in case of semi
annual interest and if the required rate of return is < the coupon rate, then
Bond value in case of annual interest should be < the bond value in case of semi
annual interest.
Illustration 8
A bond of Rs 1000 bearing a coupon rate of 10% is payable half yearly. There is
maturity period of 5 years left. What is the value of the bond? Compare it with
the situation if the interest is payable on annual basis. The required rate of return
is 12%.
Semi annual
Interest: annual = Rs 100
Semi annual: 100/2 = Rs 50
Required rate: annual = 0.12
Semi – annual: 0.12/2 = .06
Periods: 2n = 2 × 5 = 10
Bo = Interest × PVAF ( r, n) + RV × PVF (r,n)
50 × PVAF (0.06,10) +1000 × PVF (0.06,10)
(50 × 7.360) + (1000 × 0.558)
368+ 558
= Rs 926
Annual
Bo = Interest × PVAF (r,n) + RV × PVF (r , n)
100 × PVAF (0.12, 5) + 1000 × PVF(.12,5)
(100 × 3.605) + (1000 × 0.567)
360.5 + 567
= Rs 927.50
Since the required rate of return is more than the coupon rate, bond value will be
higher in case of annual interest.

150
7.5.2 Interaction between Coupon Rate, Required Rate of Fixed Income
Securities
Return and Bond Value
As pointed out above, the required rate of interest and the value of the bond vary
inversely. As the market rate of interest change, the required rate of interest will
also change. For instance, if the market rate of interest increases, the required rate
of interest increases and the bond price will fall (as the discount rate increases).
This is the major source of risk in bonds. Besides, if:

Required rate of return > coupon rate Bond value will be less than par value
(called discounted price)
Required rate of return < coupon rate Bond value will be more than par
value (called premium value)
Required rate of return = coupon rate Bond value will be equal to the par
value

Illustration 9
Suppose there is a bond with face value of Rs 1000, a coupon rate of 10% and
with a maturity period of 10 years. Find out its value at different required rate of
returns of 2, 6, 10, 12, 14, 16 percent.
When required rate is 2% the bond value will be:
Bo = Interest × PVAF(r,n) + RV × PVF(r,n)
100 × PVAF (.02,10) + 1000 × PVF(.02,10)
(100 × 8.983) + (1000 × 0.820)
898.3 + 820 = Rs 1718.3
When required rate is 6%
Bo = (100 × 7.360) + (1000 × 0.558)
736 + 558 = Rs 1294
When required rate of return is 10%
Bo = (100 × 6.145) + (1000 × 0.386)
614.5 + 386 = Rs 1000.5
When required rate of return is 12%
Bo = (100 × 5.650) + (1000 × 0.322)
565 + 322 = Rs 887
When the required rare of return is 14%
Bo = (100 × 5.216) + (1000 × 0.270)
521.6 + 270 = Rs 791.6
When the required rate of return is 16%
Bo = (100 × 4.833) + (1000 × 0.227)
483.3 + 227 = Rs 710.
151
Deterministic Cash Hence, we have the following result for different rates of required returns:
Flow Streams
Required rate of return (%) Bond value ( Rs) Interpretation
2 1718 Required rate < coupon rate
Bond value > par value
6 1294
10 1001 Required rate = coupon rate
Bond value = par value
12 887 Required rate > coupon rate
Bond value < par value
14 792
16 710

7.5.3 Time to Maturity and Valuation of Bond

If the required rate of return and coupon rate are different, the remaining time to
maturity also becomes relevant for the valuation of the bond. In such cases, the
value of bond will behave as follows:
• When the required rate of return is less than the coupon rate, the bond value
will be higher than the par value but will decline and converge to the par
value on maturity.
• When the required rate of return is equal to the coupon rate, the bond value
will remain equal to the par value throughout.
• When required rate of return is more than the coupon rate, the bond value will
be less than the par value but will increase and will be equal to the par value
on maturity.
The investors are therefore advised to:
• Not buy the bond at a high premium near the maturity as the value of the
bond will keep declining as the maturity approaches; and
• Not sell the bond at a discounted price near the maturity as the value of the
bond will be increasing as the maturity approaches.
Illustration 10
A Rs 1000 bond carries coupon rate of 10% payable annually. If the required rate
is 14%, calculate its intrinsic value if there are 10, 6, 4, 2 , 1, 0 years to maturity.
i) 10 years to maturity
Bo = Interest × PVAF (r,n) + RV × PVF (r,n)
100 × PVAF (.14,10) + 1000 × PVF (.14,10)
(100 × 5.216) + (1000 × 0.270)
521.6 + 270 = Rs 791.6
ii) 6 yrs to maturity
(100 × 3.889) + (1000 × 0.456)
152
388.9 + 456 = Rs 844.9 Fixed Income
Securities
iii) 4 years to maturity
(100 × 2.914) + (1000 × .592)
291.4 + 592 = Rs 883.4
iv) 2 years to maturity
(100 × 1.647) + (1000 × 0.769)
164.7 + 769 = Rs 933.7
v) 1 year to maturity
(100 × 0.877) + (1000 × 0.877)
87.7 + 877 = Rs 964.7
vi) 0 year to maturity
0 + 1000 = Rs 1000
Thus, as time lapses, bond price increases and converges to its redemption value
at maturity.

Check Your Progress 3

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What do you understand by valuation of financial asset? What is meant by
capitalised value? Why is it considered a realistic concept of valuation?
………………………………………………………………………………….
………………………………………………………………………………….
2) Why does the discount rate used for finding the capitalised value/intrinsic
value vary from investor to investor?
………………………………………………………………………………….
………………………………………………………………………………….
3) Explain the relationship between the required rate of return/discount rate and
the value of the bond?
………………………………………………………………………………….
………………………………………………………………………………….
4) State whether True or False:.
a) If the intrinsic value is more than the current market price the investor
will decide not to buy the bond.
b) When the required rate of return is less than the coupon rate, the bond
value will be less than the par value.
c) When required rate of return is more than the coupon rate, the bond value
will increase as the maturity decreases. 153
Deterministic Cash
Flow Streams 7.6 RISKS IN BONDS
Against the common belief, investment in bonds is also subject to risks.
However, investment in bonds has less risk as compared to equity shares.
Some major sources of risk in bonds are:
1) Interest Rate Risk: It is the most important source of risk in bonds as also in
other fixed income securities. If interest rates change, there will be a change
in the market price of the bonds. For example, a rise in interest rate will
depress the market price of the bonds as there is an inverse relationship
between bond price and interest rate. On the other hand, as the interest rate
declines, bond price will increase.
When interest rate rises in the market (say from 10% to 12%), the bond
carrying a fixed coupon rate (of say, 10%) becomes unattractive for the
investors as new bonds in the market are available at a higher rate (12%).
The reverse will be the case when the rate of interest in the market declines.
The current investment in bond will become attractive as it will provide a
higher interest income.
Reinvestment Rate Risk: Bonds pay periodic interest which the investor may
reinvest. If the interest rates in the market fall, there is a risk that the investor will
have to reinvest their interest at a lower rate. Investors having bonds with longer
maturity and in which the company is paying regular and higher interest will be
more exposed to this risk. On the other hand, if the rate of interest in the
market increases, the investor will benefit with an opportunity to invest interest at
a higher rate.
Combining interest rate risk and the reinvestment rate risk, the investor is
exposed to two types of risks that work in opposite directions. Thus when
interest rate rises, bond price will fall. The Bond holder will get an
opportunity to earn higher return on reinvestment of interest. The gain will
reduce the amount of loss due to fall in bond price.
When interest rate declines, Bond price will increase. Bond holder will be able
to earn a lower return on reinvestment of interest. This loss will reduce his gain
due to increase in bond price.
2) Inflation Risk: Interest rates on bonds are defined in nominal terms whereas
what is more relevant is the real rate of interest. Since the purchasing power
of money declines due to inflation, real income from the bond will not be the
same as its nominal income. Longer the maturity period, greater is the
inflation risk.
3) Default Risk: The issuer of the bond may loose his capacity to pay interest
and the principal amount on time. One can get an idea of the default risk by
seeing its credit rating. Bonds with high default risk will have a low credit
rating and vice versa.

154
4) Call Risk: When the interest rate declines, the issuer may exercise the call Fixed Income
Securities
option in case of callable bonds. The investor will have to accept the
premature redemption and will have to reinvest at a lower rate.
5) Liquidity Risk: Most debt instruments do not have a very liquid market. This
makes it difficult for the investors to offload their investment in debt
instruments. They may have to accept a discount over the quoted price.
Event Risk: Sometimes, for reasons like natural calamities, a government
change, takeover, or restructuring, etc. there might be a change in the firm’s
ability to pay interest and the principal payments.

Check Your Progress 4

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What is interest rate risk?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
2) Why does your current investment in bonds become less attractive if the rate
of interest in the market increases?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
3) What is meant by inflation risk on bonds?
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
………………………………………………………………………………….
4) State whether True or False:.
a) Investment in bonds is free from default risk.
b) When interest rate increases, the bond price will fall.
c) When interest rate decreases, the bond holder will be able to earn a lower
return on reinvestment of interest.
d) When interest rates increase, the issuer may exercise the call option.
e) Bonds have a highly liquid market.

155
Deterministic Cash
Flow Streams 7.7 LET US SUM UP
The unit explained certain important features of fixed income securities with a
focus on bonds and debentures. It explained the classification of corporate fixed
income securities, other securities and bonds.
The concept of yield, and its various types, that give important rules of sound
investment decisions was explained. All the concepts are explained with
numerical illustrations.
The valuation of bonds with the help of required rate of return becomes important
for an investor to take correct investment decisions. Out of various valuation
models, the capitalised value is the best. When not to buy at premium, or not to
sell at a discount, is explained in the unit with reference to the balance time to
maturity. Since all investments are subject to risk, sources of risk in fixed income
securities are enumerated.

7.8 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1
1) See section 7.2 and answer.
2) See section 7.3 and answer
3) See subsection 7.2.1 and answer.
4) See subsection 7.2.1 and answer.

Check Your Progress 2

1) Bond yield refers to the percent return which an investor realises on his
investment in a bond. It may be different from the market rate of interest or
the required rate of return. Yield provides the actual return from bond and
helps in making a rational decision. Yields are always expressed on annual
basis.
2) YTM is defined as the rate of return that will be earned if a bond is purchased
at the current market price and held till the maturity. For callable bonds the
maturity period (n) is not relevant as the company may retire it before
maturity. In case of callable bonds, thus, YTM is not calculated. In such
bonds, YTC is calculated for the period up to the date when the bond can first
be called and redeemed. An investor may not hold bond till the maturity and
offload it anytime for a variety of reasons. YTM will not be relevant for such
investors as his holding period is less than the total maturity period and YTM
does not consider the market value before maturity. Then Holding period
return is calculated
156
 Fixed Income
3) For holding period return the interest and capital gain (or loss) will be Securities
expressed as a percentage of the purchase price.
Total int income + (Bs − B0 )
HPR =  100
B0

where Bs is the sale price of bond, Bo is the purchase price

4) a. False b. True c. True

Check Your Progress 3

1) See subsection 7.5.1 and answer.
2) See subsection 7.5.2 and answer
3) See subsections 7.5.2 and 7.5.3 and answer.
4) a. False b. False c. True

Check Your Progress 4

1) Interest rate risk is the most important source of risk in bonds and other fixed
income securities. If interest rates change, there will be a change in the
market price of the bonds.
2) When interest rate rises, bond price will fall. Bond holder will get an
opportunity to earn higher return on reinvestment of interest. The gain will
reduce the amount of loss due to fall in bond price.
3) Inflation risk can be explained as follows. Interest rates on bonds are defined
in nominal terms whereas what should be more relevant is the real rate of
interest. Since the purchasing power of money declines due to inflation, real
income from the bond will not be the same as its nominal income. Longer the
maturity period, greater is the inflation risk.
4) a. False; b. True; c: True; d. False; e. False

157
Deterministic Cash
Flow Streams

158