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Fixed Investment Management

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Fixed Investment Management

Case Background

The board of trustees of the endowment of the Amboli Golf Club (AGC) included several professionals who gathered four times each year during second week of January, April, July and October to evaluate the performance of their fund. The trustees of the AGC, every year, sought advice from the Fixed Investment Management (FIM), Mumbai over which bonds to buy. Typically, AGC would provide FIM with certain medium term goals and FIM would get back to AGC with recommendations as to which bonds would meet those goals. FIM managed a fixed income portfolio of the Rs. 50 Crores for AGC.

The trustees of AGC wished to preserve the principal, hence invested in relatively safer bonds. While the trustees were all professionals, none of them was an expert on the financial matters, and they evaluated the bonds based on the previous performance. Post the cut in GOI rates to 6.549% from 7.783% by the RBI, the trustees were looking for a safe bond which would also provide them with high yield.

Fixed Income Management, post receiving the investment goals from the AGC, held meetings to zero in on one bond which they would put forward to the trustees as their recommendation. In January 2017, after receiving the direction of finding a safe and high yield bond, Robert organised a meeting with its analysts to come to a final recommendation. Four bonds were proposed by the team of analysts which were GOI Treasury Bond at 8.08%, State Bank of India Bond at 10.1%, DS Kulkarni Developers Limited Bond at 12.75% and Andhra Pradesh State Financial Corporation Bond at 9.15%. The analysts used the ratings of these bonds are provided by Crisil to assess the risk attached. Now as part of the meeting, the coupon rate and the last traded price for each of the bonds was available, however, yield was yet to be determined. The bond which would provide the best combination of yield and risk would become the final recommendation of FIM to the trustees of AGC.

Financial Aspects

Following are the key financial aspects pertaining to the case:

  1. Interest Accrued

For the purpose of assessing the bonds, the analysts have overlooked the interest accrued on each of the bonds since the last release of coupon amount.

The interest is accrued on each instalment of the coupon between one payment date to another. While determining the net value of a bond it is important to adjust the cash flows for the interest accrued if the bond purchase date is not same as the coupon payment date. For instance, if the number of days between coupon payment dates is and the first period is not exactly a full coupon period then the coupon size must be calculated as DCF×c, where DCF is calculated as the day count fraction between the dated date and the first coupon date using the correct day count convention.

  1. Duration and Volatility of Bonds

Financial managers and investors often monitor duration of a bond so as to assess how the bond prices change with the interest rate changes unlike the analysts at FIM. The duration is the weighted average of the times to each of the cash payments. The times are the future years extending to the final maturity date which we call T. The weight for each year is the present value of the cash flow divided by the total present value of the bond.

Duration = Σ 1 x PV (C1)/PV

Where the summation runs over the period of the bond.

The duration of the bond is also used to determine the volatility of the bond which is given as:

Volatility (%) = Duration / (1 + yield)

The value basically denotes the change in the price of the bond for 1% change in the interest rates.

  1. Safe Bonds with high yields

The analysts at FIM were looking for bonds which would provide a high yield but at the same time would be low on risk. This apparently was very difficult to be achieved at the same time because so as to achieve a high yield the bond by nature should be volatile enough to register a surge in its price. Bonds which floated closer to the par value by default become the ones with maximum yield for the lower variability.

  1. Risk Aversion at AGC

Being in a fixed income market, the trustees wished to preserve their principal at all costs, thereby having high aversion to risk. This limited the scope for the analysts at FIM as the bonds with highest of the yields always have a higher risk associated.

Analysis and Interpretations

As part of analysing the four bonds, we are required to find the bond which would provide the most favourable combination of risk and yield. So as to determine the price of a bond we discount the cash flows associated with a bond at interest rate and the cash flow being the fixed amount calculated using the coupon rate of the bond.

Therefore for a coupon rate of of C and interest rate of r, we get the price of a bond as:

P = C [Σ 1/ (1+r) ^t] + Bond Face Value / (1+r) ^t

Where t is the time period of maturity of the bond,

C is the annual/semi-annual cash flow that the bond returns,

R is the interest rate at which we discount.

Now once we know the figure at which the bond is priced and we have the annual cash flows, we determine the rate r which forms the yield to maturity for the bond. Because of multiple cash flows involved, it almost impossible to determine the yield of a bond by solving the mathematical equation that would unfold. We use the method of trial and error to estimate the yield to maturity associated with the given cash flow. While doing this trial and error, we keep the following points in consideration:

  1. As the price of the bond falls, the rate must have increased because of the inverse relation the two values have.
  2. The price when higher than the face value is said to be at premium, if lower is called as selling at discount.
  3. Using the first point, we can say when the bond is selling at premium, we need to increase the rate so as to get closer to the price level.

We will employ the above understanding to the four bonds which are being discussed as the meeting being held at FIM, so as to determine the yield they were offering.

GOI Treasury Bond

The GOI Treasury Bond was due for maturity in almost five years of time at 2nd of August, 2022. The coupon rate of the bond was set at 8.08% while the coupon payment, as in the cash flow, would occur annually. The bond is considered to be one of the safest ones with a rating of AAA by Cirisil. The last traced price for the bond was 105.55 percent.



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