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UNDERSTANDINGDEBT MARKETS
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What is the Debt Market?
The Debt Market is the marketWhere fixed income securities of various types and features are issuedand traded
Securities Issued by:
Central and State Governments,Municipal Corporations,Govt. bodiesFinancial InstitutionsBanksPublic Sector UnitsPublic Ltd. companiesStructured Finance Instruments
What is the Money Market?
Money market instruments are fixedincome instruments, generally havingmaturity less than 1 year and arediscounted instruments.
The Money
Market is basically concerned with theissue and trading of securities withshort term maturities or quasi-moneyinstruments
Basic of Debt Market
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Why should one invest in Fixed Income Securities?
Fixed Income securities offer a predictable stream of payments by way of interest and repayment of principal at the maturity of the instrument. The debt securities are issued by the eligible entitiesagainst the moneys borrowed by them from the investors in these instruments. Therefore, most debtsecurities carry a fixed charge on the assets of the entity and generally enjoy a reasonable degree of safety by way of the security of the fixed and/or movable assets of the company.
The investors benefit by investing in fixed income securities as they preserve and increasetheir invested capital and also ensure the receipt of regular interest income.
The investors can even neutralize the default risk on their investments by investing in Govt.securities, which are normally referred to as risk-free investments due to the sovereignguarantee on these instruments.
The prices of Debt securities display a lower average volatility as compared to the prices of other financial securities and ensure the greater safety of accompanying investments.
Debt securities enable wide-based and efficient portfolio diversification and thus assist inportfolio risk-mitigation.
Basic of Debt Market
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What are debt Instruments?Debt instruments represent contracts whereby one party lends money to another on pre-
determined terms with regard to rate of interest to be paid by the borrower to the lender, theperiodicity of the said interest payment, and the repayment of the principal amount borrowed
Key Features of a Debt instrument
CouponZero Coupon BondsTreasury STRIPSFloating Rate BondsDeferred Interest BondsStep-up BondsExtendible Reset Bond
Maturity
Callable Bonds Putable Bonds Convertible Bonds
Principal Amortising Bonds Bonds with Sinking Funds
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Government Securities
Corporate Bonds
Money Market
Segments in the Debt Market
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Participants and Products in the Debt Markets
FINANCIAL MARKET
MONEYMARKET
DEBTMARKET
FOREXMARKET
CAPITALMARKET
G-SECS BONDS
Corporate
Securities
PSU
BONDS
FI
BONDS
STATE
Govt.
CENTRAL
Govt.
T-BILLSCALL / NOTICETERMSMONEY
CD ICD CP REPOCOMMERCIAL
BILL
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Participants and Products in the Debt Markets
Market Segment Issuer Instruments
Government Securities
Public Sector Bonds
Public Sector Bonds
Private Sector Bonds
Private Sector Bonds
Central Government
State GovernmentGovernment Agencies /Statutory Bodies
Public Sector Units
Corporates
Banks
Financial Institutions
Zero Coupon Bonds, Coupon BearingBonds, Treasure Bills, STRIPS
Coupon Bearing Bonds.
Govt. Guaranteed Bonds, Debentures
PSU Bonds, Debentures, CommercialPaper
Debentures , Bonds, Commercial Paper,Floating Rate Bonds. Zero CouponBonds, Inter-Corporate Deposits
Certificates of Deposits, Debentures,Bonds
Certificates of Deposits, Bonds
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Government Securities (GSec)
Borrowing by Government of IndiaCategorised as Sovereign Debt thus ZERO Credit RiskNormally available with maturities of 1 yrs to 30 yrsRBI announces the auction of government securities through a press notification, and invites bids.Choices of Treasury Auctions
Discriminatory Price Auctions (French) Uniform Price Auction (Dutch)
Price Based Auction
Yield Based Auction
SGL Accounts*
Constituent SGL Accounts
**SGL stands for 'Subsidiary General Ledger' account. It is a facility provided by RBI to large banks and financial institutions to hold their investments in Governmentsecurities and Treasury bills in the electronic book-entry form.
As all investors in Government securities do not have an access to the SGL accounting system, RBI has permitted such investors to hold their securities in physical stockcertificate form. They may also open a Constituent SGL account with any entity authorised by RBI for this purpose and thus avail of the DVP settlement. Such client accounts
are referred to as Constituent SGL accounts.
Long Term (> 1 year) Debt Products Used by Long Term Debt/Income Funds
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Corporate Debt Market
The market for long term corporate debt has two large segments:
Bonds issued by public sector units, including public financial institutions, andBonds issued by the private corporate sector
Long Term (> 1 year) Debt Products Used by Long Term Debt/Income Funds
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Credit rating is primarily intended to systematically measure credit risk arising from transactions
between lender and borrower.
Credit risk is the risk of a financial loss arising from the inability (known in credit parlance as default) of the borrower to meet the financial obligations towards its creditor
Credit Ratings
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Independent Opinion on credit worthiness of an issuer,
awarded by a registered credit rating agency.Both Quantitative and qualitative researchOnly credit opinions, no guaranteesCan be different grades by different agenciesCredit Rating agency appointed by the issuerAdvantages of Credit rating
Issuer:-Widen investor baseLower cost of fundsHigher financial flexibility
Investor
Independent assessment of credit worthinessImproved liquidity of the paperhelp in valuing a security
Credit Ratings
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In India, it is mandatory for credit rating agencies to register themselves with SEBI
and abide by the SEBI (Credit Rating) Regulations, 1999.
There are 4 SEBI registered credit rating agencies in India, namely:
CRISILLong Term: AAA to D
Short term: P1+ to P5ICRA
Long term: LAAA to LDShort term: A1+ to A5
FitchLong term: AAA to DShort term: F1+ to F5
CARELong term: CARE AAA to CARE DShort term: PR1+ to PR5
Credit Rating
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High Investment GradesAAA (Triple A) Highest SafetyAA (Double A) High Safety
Investment GradesA Adequate Safety Changes in circumstances can adversely impact
such issue more than higher rated issuesBBB (Triple B) Moderate Safety changing circumstances are likely tolead to weakened capacity
Speculative Grades BB (Double B) Inadequate SafetyB -High RiskC Substantial RiskD Default
Credit rating from CRISIL (An example)
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What is Commercial Paper (CPs)?
Short-term instrument (less than 12 months), introduced in 1990, to enable nonbanking companies to borrow short-term funds through liquid money market instruments.
Intended to be part of the working capital finance for a corporate
Mandatory for CPsto be credit rated
What are Certificates of Deposit (CDs)?
Short-term borrowings by banks (Less than 12 months)
Rates are higher than the term deposit rates on account of low costs for bulk mobilization
as compared to retail deposits
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What are REPOs?
REPOS are better known as Repurchase Agreements, a sale & a Repurchase Agreementhas a borrower sell securities for cash to a lender and agree to repurchase to repurchasethose securities at a later date for more cash. A reporters the difference between borrowedand paid back cash expressed as a percentage
In Indian Financial System, RBI accepts approved securities from member banks in
exchange for cash at a predefined rate called the repo rate. REPO rate thus is the rate atwhich RBI lends to banks in exchange for securities
Repos are popular because they can virtually eliminate credit problems
Reverse-Repoby the central banks acts as a floor to call money market
Repo and reverse-repo together become corridor for call money market
Worldwide Central Bankers use Repost manage Money Supply in the economy
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Repo Transaction
Difference between cash given by RBI & received back is Repo Rate
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What are CBLOs?
Collateralized Borrowing & Lending Obligation (CBLO) -Money market instrumentapproved by RBI
Developed by CCIL (Clearing Corporation of India Ltd.) for the benefit of the entities whohave either been phased out from inter bank call money market or have been givenrestricted participation
CBLO is a discounted instrument available in electronic book entry form for the maturityperiod ranging from 1 day to 90 Days (as per RBI guidelines can be uptoa year).
Dealing System through:
Indian Financial Network (INFINET), a closed user group to the Members of the NegotiatedDealing System (NDS) who maintain Current account with RBI.
Internet gateway for other entities who do not maintain Current account with RBI.
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CBLOContinued
Mutual Funds are major lenders
Primary Dealers are major borrowers
Transaction Denomination INR 5 M
Auction basis Discount rate & Maturity
Unlike REPO, lenders here can call their funds and borrowers can repay beforematurity by unwinding their position
Participants Banks, MFs, Co-operative Banks, FIs, Insurance Companies, NBFCs,Corporate, Provident/Pension Funds
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What are T-Bills?
Short-term debt instruments issued by the Central government.
Currently 3 types of T-bills are issued, 91-day, 182 -day and 364-day.
Sold through an auction at a discount to face value
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BOND VALUATION
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Fundamentals of Valuation
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Bond Valuation An Example
Principal Amount = Rs.100000
Coupon = 12% p.a.
Installment = Annual
Maturity (n) = 5 yrs
Present Interest rate in the market / Discount Rate(r)= 8% p.a.
Present Value of Cash flow over 5 Years of this Bond = 12000/((1+8%)^1 +12000/(1+8%)^2.(12000+100000)/(1+8%)^5
Present Value of all Cash flow of this bond = 1,15,970.80
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Yield
Yield refers to the percentage rate of return paid on a stock in the form of dividends, or the effective
rate of interest paid on a bond or note
There are many different kinds of yields depending on the investment scenario and the characteristicsof the investment
Current Yield is the coupon divided by the Market Price and gives a fair approximation of the presentyield
Current Yield = Coupon of the Security(in%) x Face Value of the Security(viz. 100 in case of G- Secs.)/Market Price of the SecurityEg: Suppose the market price for a 10.18% G-Sec 2012 is Rs.120. The current yield on thesecurity will be (0.1018 x 100)/120 = 8.48%
The yield on the government securities is influenced by various factors such as level of money supply in
the economy, inflation, future interest rate expectations, borrowing program of the government & themonetary policy followed by the government
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Yield To Maturity
Yield To Maturity (YTM) is the most popular measure of yield in the Debt Markets and is thepercentage rate of return paid on a bond, note or other fixed income security if you buy and holdthe security till its maturity date
Yield to maturity on a bond is also called the Internal Rate of Return (IRR)
The calculation for YTM is based on the coupon rate, length of time to maturity and market price.
It is the Internal Rate of Return on the bond and can be determined by equating the sum of thecash-flows throughout the life of the bond to zero. A critical assumption underlying the YTM isthat the coupon interest paid over the life of the bond is assumed to be reinvested at the samerate
The YTM is basically obtained through a trial and error method by determining thevalue of the entire range of cash-flows for the possible range of YTMsso as to find
the one rate at which the cash-flows sum up to zero.
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Types of yield curve NormalCurve Flat Curve Inverted Curve
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Yield Curve
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The difference between the yield on a corporate bond and government bond is called the credit
spread( Also called the yield spread)
Credit Spread
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Movement in Credit Spreads of 10 Y AAA Corp BondV/s 10 Y Govt. Bond10Y
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Duration is the weighted average term to maturity
Duration of a bond is less than its maturity except for zero coupon bond
Duration is longer the longer the maturity except for deep discount bonds
As YTM increases, duration decreases
Duration
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The modified duration of a bond measures the percentage change in its price for agiven change in interest rates or yields
Modified Duration = Duration/ (1+ytm)
Modified duration measures the risk of the bond with respect to changes in the yield,
in other words it is the price risk of the bond with a unit change in yield, in generallonger duration bonds carry more price risk for a given change in yield and vice versa
Modified Duration
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The basic bond valuation equation shows that the yield and price are inversely related
This relationship is however, not uniform for all bonds, nor is it symmetrical forincreases and decreases in yield, by the same quantum
Price-yield relationship between bonds is not a straight line, but is convex.
The sensitivity of price to changes in yield in not uniform across bonds.
Higher the term to maturity of the bond, greater the price sensitivity.
Lower the coupon, higher the price sensitivity. Other things remaining the same, bonds
with higher coupon exhibit lower price sensitivity than bonds with lower coupons.
Price-Yield relationship in Bonds A few pointers
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Price-Yield relationship in Bonds GraphicalRepresentation Price / Yield Graph (10Y Govt Security)
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Overall Return = Interest return + Capital return due to change in interest rates
In a falling interest rate scenario, the overall returns would be high and vice versa in arising interest rate scenario.
In a falling interest rate scenario, the overall returns would depend on the duration of the bond and the current yield of the bond
Calculation of return from debt instruments
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Volatility due to change in Interest rate Change inBond Price vs Duration for 1% Yield Change-
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About Pass ThroughCertificates (PTCs)
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When certain financial asset classes (retail or corporate) are pooled together and undivided interestin the pool is sold, pass -through securities are created
The term 'undivided interest' means that each holder of the security has a proportionateinterest in each cash flow generated by the pool
The pass-through securities assure that cash flow from the underlying asset classeswould be passed through to the holders of the securities in the form of regular paymentsof interest and principal
The entity selling the receivables (also usually the originating entity) to the Trust is calledthe Originator' and the entity which has borrowed the funds and is responsible for
repayment is the obligor
Nature of a Typical PTC transaction: First, a special purpose vehicle (SPV) is created, to de-link the pool assets (cash flows)from the company that wants to securitise(the `originator'). The SPV is usually a trustand has no borrowings of its own
The SPV then issues tradable debt instruments called `pass through certificates' and sells
them to potential investors. Proceeds from the sale of PTCsare then utilized by the SPV topurchase/ buy-out the asset pools from the Originator
In a typical securitization deal, assets in the pool include auto loans, Commercial vehicle (CV) andconstruction equipment (CE) loans, personal loans OR single corporate loans
Since the SPV is a set up as a bankruptcy remote entity, it is not impacted by bankruptcy of theoriginator
Background
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Schematic Representation of a PTC Transaction
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The PTC market in India can be broadly segregated into two categories viz Single corporate loans. Herein, a loan given by an originator (Bank/ NBFC/ FI etc.)to a single entity (obligor) is converted into pass through certificates and sold to endinvestors
Retail asset pools comprising multiple borrowers and asset classes such as Personalloans, Credit Card receivables, Construction Equipments, Commercial Vehicles,passenger cars and two wheelers
Difference between Retail pool PTC transactions different from Single Loan PTCs Unlike single loan sell-downs, the retail asset pools comprise several differentborrowers within multiple asset classes. A transaction may involve either a singleasset class (such as CVs or CEs) or a composite pool comprising multiple assetclasses
In retail pool transactions, the exposure is towards several small ticket borrowersand hence the methodology of analysis (explained later) is different from that
followed for single loan PTCs, wherein the exposure is on the corporate borrower Retail pool PTCs in majority of the cases are rated the highest (i.e. AAA) owing tothe stipulation of a cash collateral, unlike single loan PTCs, wherein the rating ismostly the same as the stand-alone rating (in the absence of any creditenhancement) enjoyed by the issuer on other instruments such as debentures andbonds
Different Types of PTC transactions
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All PTCs are rated by one of the four accredited rating agencies in the country
The rating is based on the financial strength of the obligor, as the end-investors have no recourse tothe originator of the loans
Effectively the rating on the PTCs represents the stand -alone credit risk of the obligor
The rating takes into account the relative repayment ability of the obligor
Ratings for PTCs
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There is no difference in the credit risk on the exposure taken through a single loan PTC vis--vis aplain vanilla debenture
Credit risk assessment in a PTC investment is based on the analysis of the obligor and notoriginator of the loan
The methodology adopted to evaluate the credit risk in the case of a single loan PTC is identical tothat followed in the case of investment in debentures / CPsor other financial instruments issued by the obligor
Nature of risks in PTCs
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Debt FundInvesting - Risk
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Default Risk: This can be defined as the risk that an issuer of a bond may be unable to maketimely payment of interest or principal on a debt security or to otherwise comply with theprovisions of a bond indenture and is also referred to as credit risk
Interest Rate Risk: can be defined as the risk emerging from an adverse change in the interestrate prevalent in the market so as to affect the yield on the existing instruments. A good casewould be an upswing in the prevailing interest rate scenario leading to a situation where theinvestors' money is locked at lower rates whereas if he had waited and invested in the changed
interest rate scenario, he would have earned more
Reinvestment Rate Risk: can be defined as the probability of a fall in the interest rate resulting ina lack of options to invest the interest received at regular intervals at higher rates at comparablerates in the market
Risks associated with Debt Securities
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Counter Party Risk: is the normal risk associated with any transaction and refers to the failure or
inability of the opposite party to the contract to deliver either the promised security or the sale-value at the time of settlement
Price Risk: refers to the possibility of not being able to receive the expected price on any orderdue to a adverse movement in the prices
Risks associated with trading in Debt Securities
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Probability of default by the borrower
Change in credit rating downgrade increases the yield & decreases the price upgrade decreases the yield & increases the price
Spread
The payoff for assuming credit risk
Credit Risk
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