Security Analysis & Portfolio Management

ASSIGNMENT 2
Security analysis & Portfolio
Management

Name: Anika Varkey

Roll No.: 18
Topic: Bond as a Financial Instrument: Analysis
PGDM 2015 2017
Bond as a Financial Instrument: Analysis

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Security Analysis & Portfolio Management

Bond: Meaning and Features
A bond is a type of investment that represents a loan between a borrower and a lender.
In other words, Bonds are securities, confirming the companys (issuers, which has
issued the bonds) debt to investor.
With bonds, the issuer promises to make regular interest payments to the investor at a
specified rate (the coupon rate) on the amount it has borrowed (the face amount)
until a specified date (the maturity date). Once the bond matures, the interest
payments stop and the issuer is required to repay the face amount of the principal to the
investor. Because the interest payments are made generally at set periods of time and
are fairly predictable, bonds are often called fixed-income securities.
Coupon rates are most often fixed the rate of interest stays constant throughout the
life of the bond. However, some bonds have variable or floating coupon rates
(interest payments change from period to period based on a predetermined schedule or
formula).
Some bonds pay no interest at all until maturity. Because bondholders are creditors
rather than part owners, if a corporation goes bankrupt, bondholders have a higher
claim on assets than stockholders. This provides added security to the bond investor
but does not completely eliminate risk.
The interest for bonds is usually paid in two ways:
1. In the course of the entire bonds validity period, the coupon is paid at the
determined frequency or in the end of the period.
2. Bonds are sold with discount (discount bonds) and repurchased for a nominal
value.

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Types of Bonds:
1. Fixed Rate Bonds
In Fixed Rate Bonds, the interest remains fixed throughout the tenure of the bond.
Owing to a constant interest rate, fixed rate bonds are resistant to changes and
fluctuations in the market.
2. Floating Rate Bonds
Floating rate bonds have a fluctuating interest rate (coupons) as per the current
market reference rate.
3. Zero Interest Rate Bonds
Zero Interest Rate Bonds do not pay any regular interest to the investors. In such
types of bonds, issuers only pay the principal amount to the bond holders.
4. Inflation Linked Bonds
Bonds linked to inflation are called inflation linked bonds. The interest rate of
Inflation linked bonds is generally lower than fixed rate bonds.
5. Perpetual Bonds
Bonds with no maturity dates are called perpetual bonds. Holders of perpetual bonds
enjoy interest throughout.
6. Subordinated Bonds
Bonds which are given less priority as compared to other bonds of the company in
cases of a close down are called subordinated bonds. In cases of liquidation,
subordinated bonds are given less importance as compared to senior bonds which
are paid first.

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7. Bearer Bonds
Bearer Bonds do not carry the name of the bond holder and anyone who
possesses the bond certificate can claim the amount. If the bond certificate gets
stolen or misplaced by the bond holder, anyone else with the paper can claim the
bond amount.
8. War Bonds
War Bonds are issued by any government to raise funds in cases of war.
9. Serial Bonds
Bonds maturing over a period of time in installments are called serial bonds.
10. Climate Bonds
Climate Bonds are issued by any government to raise funds when the country
concerned faces any adverse changes in climatic conditions.
11. Secured and Unsecured:
Secured bonds have specific assets assigned to them as collateral. Unsecured or
debenture bonds are issued against the general credit of the company. Therefore,
these are used by companies with a good credit rating.
12. Term Bonds:
When bonds mature at a single, specified date, they are known as term bonds.
13. Redeemable/Retractable:
Redeemable or callable bonds can be retired (repaid) for a stated dollar amount
prior to their maturity, at the option of the issuer. Retractable bonds can be
redeemed any time before maturity, at the option of the bondholder.

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The Benefits of investing in Bonds
Income predictability:
If your objective is to maintain a specific, steady level of income from your portfolio,
high quality bonds can provide a series of predictable cash flows with minimal risk to
your invested capital (the principal).
Safety:
Depending on their quality, bonds can offer you a high degree of certainty that the
interest and principal repayment will be received in full if the bond is held to maturity.
The quality of the bond and the level of security that comes with it is reflected in the
credit rating of the issuer.
Diversification:
Diversification means holding a mix of different asset classes in your portfolio. For
example, adding fixed-income securities like bonds to an equity portfolio helps you
achieve greater diversification. This is a way to reduce portfolio risk the risk inherent
in your combined investment holdings while potentially increasing returns over time,
since even if one class declines in value, there is still an opportunity for an increase in
one or more of the other classes.
Choice:
A wide range of bond issuers with a variety of coupon rates and maturity dates are
available for you to choose from. This allows you to find the bond(s) with cash flows that
match your income needs while complementing your other portfolio holdings.
Investors benefit (in short)
Clear investment return, if bonds are kept until repurchase.
A possibility to sell bonds in the secondary market until repurchase.
The price of bonds in the secondary market changes depending on the current market
interest rate, thus, there is a possibility to obtain a return without keeping the bonds
until repurchase.
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Investors risk
When buying bonds, contrary to what is thought, it is required to comprehensively
evaluate the risk of the company, issuing these bonds, in the way you would consider
buying the shares of that company. Government bonds make an exception of this rule,
because governments bankrupt much rarer than companies do.
The price of secondary markets bonds (yield) similarly to the price of shares depends on
their liquidity. Liquidity is a possibility of the available assets to be within the shortest
possible time and with the least possible expenses to be converted into cash money.
Thus, the greater the liquidity of bonds is, the more probable is that they will
be traded easier without significant expenses.
The fluctuation in bond prices on the market depends on the term
remaining until repurchase of the bond. Bonds with a longer term before
repurchase are more sensitive to interest changes on the market. By investing in longerterm bonds you can earn more or lose more if you sell them without waiting until
repurchase.
The risk on an interest-bearing instrument consists partly of price changes that may
occur during the term, because market interest rates change and partly of the risk that
the issuer will be unable to repay the loan. Loans where full security for repayment is
provided are thus less risky than loans without security.
The risk of loss on interest-bearing instruments is considered to be lower than for
shares. In the bond market, the market interest rate is determined each day, both on
instruments with short terms (less than one year). Market interest rates are affected by
analyses and assessments that major institutional market participants make with regard
to the development of economic factors, such as inflation, GDP growth, and the likely
development in interest rates in the country in the short and long term.
If market interest rates rise, the price of previously issued interest-bearing
financial instruments will fall if they have a fixed interest rate, as new loans
are issued with interest rates that follow the relevant market rates and thus
provide a higher interest return than available on the previously issued
instrument. Conversely, the price on previously issued instruments will rise when
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market interest rates fall. Loans issued by the state, counties and municipalities (or
guaranteed by such organizations) are regarded as being risk free with respect to
redemption at the predetermined value.
The risk of default (also known as credit risk):
An issuer of debt is said to be in default when the issuer is unable to repay the principle
or interest as scheduled. Government of India bonds have virtually no risk of default.
Corporate bonds are more exposed to default risk because companies cannot raise taxes
when there is a cash shortfall or take advantage of other options Available to
governments. Because the financial health of a company may change during the life of a
bond, it is important to watch for changes. Investors can assess the likelihood of default
inherent in a bond by watching its credit rating.
Price risk:
If you sell your bonds prior to their maturity, their price or market value may be lower
than the price at which you bought them. Price fluctuates throughout a bonds lifetime
and may be greater or less than its face or principal value. If you buy a bond below par,
you can expect to realize a capital gain when the bond matures; similarly, if you bought
the bond at a premium, you will have a capital loss at maturity. A bonds price is a
function of the bonds coupon rate as compared to the current level of interest, its
remaining term to maturity, its credit or default risk and any special features it may
have.

Why Do Companies Issue Bonds?

At some point in a company's life, it will need to generate funds to finance major
projects or plant expansion.
Issuing has the following Advantages:
Shareholder control is not affected, as bondholders do not have voting rights.
Therefore, existing shareholders retain full control of the company.

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Tax savings will result, as bond interest is deductible for income tax purposes.
Dividends are not.
Earnings per share may be higher, as the dividends paid will not be diluted further by
additional shares. Therefore, each share retains its earning per share ratio.
There are Disadvantages to issuing bonds:
Interest must be paid on a periodic basis.
The principal (face value) will have to be repaid upon maturity of the bond. By
comparison, common shareholders are not promised dividends on a regular basis, and
their investment does not have to be repaid at any time.

Three common ways to invest in bonds

1. Over-the-counter (OTC) market: Individual bonds are not bought on a central
exchange such as the Bombay Stock Exchange.
2. Mutual/investment funds: Bond or balanced mutual funds are an indirect
method of investing in bonds. These products combine professional management with
exposure to a basket of bonds that have varying maturity dates and levels of quality.
However, unlike direct bond investments, mutual funds do not have a stated maturity
date or coupon rate, making the size and timing of your cash flows uncertain. It may
also be difficult to determine the quality of the bonds held in the fund or the general
level of risk.
Mutual funds charge investors a management fee that incorporates fees paid out to
advisors.
3. Exchange-traded funds (ETFs):
ETFs are mutual fund trusts whose units trade on a stock exchange, such as the BSE.
Some ETFs expose you to an entire bond market index, while others try to track the
performance of a government benchmark bond. Risk levels vary depending on the ETF
selected.
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