Question

Explain why a company should invest in a Fixed Rate Bond, what type of callable provision would be best, and when the bond will provide a yield to the company’s portfolio.

Answer 1

Solution:

Fixed Rate Bond: owning a fixed rate bond as a standard retail investor is that you get a defined income stream, through its coupons. If you are choosing to own the bond for the duration of its life then the yield to maturity that you buy it at will equate to your return on investment.

Bonds suit people who want the flexibility of having a defined income stream (as opposed to irregular dividends) and who are more risk adverse, a bond is senior to equity.

Interpreting what you mean by investment angle, I assume this means as a short term investment. If you have a specific view on interest rate movements or the credit quality of an issuer then you can make a play and buy (or short) a bond then sell (or buy it back) it when the time is right. The advantage of this is you can make quicker gains.

Call Provision:

A call provision is a stipulation on the contract for a bond—or other fixed-income instruments—that allows the issuer to repurchase and retire the debt security.

Call provision triggering events include the underlying asset reaching a preset price and a specified anniversary or other date being reached. The bond indenture will detail the events that can trigger the calling of the investment. An indenture is a legal contract between the issuer and the bondholder.

If the bond is called, investors are paid any accrued interest defined within the provision up to the date of recall. The investor will also receive the return of their invested principal. Also, some debt securities have a freely-callable provision. This option allows them to be called at any time.

yield to the company’s portfolio:

Yield in the case of bonds In the case of a bond, the yield refers to the annual return on an investment. The yield on a bond is based on both the purchase price of the bond and the interest promised – also known as the coupon payment. Although a bond’s coupon rate is usually fixed, its price fluctuates continuously in response to changes in interest rates in the economy, demand for the instrument, time to maturity, and credit quality of that particular bond. As a result, after bonds are issued, they trade at premiums or discounts to their face values until they mature and return to full face value.

Eg:

          Let’s say a bond’s face value is Rs 1,000 on which an investor can earn 5%. This means that the coupon is 5% and an investor who buys the bond and holds it till maturity will get Rs 50 every year over the tenure of the bond. Now the price of the bond drops in the market to Rs 980. That means the current yield is Rs 50 divided by Rs 980 = 5.10%. Later, the price of the bond rises to Rs 1,030. That means the current yield is Rs 50 divided by Rs 1,030 = 4.85%. As the price of the bond fell, its yield increased. Because yield is a function of price, changes in price result in bond yields moving in the opposite direction. There are two ways of looking at bond yields - current yield and yield to maturity.