Chapter 8: Fixed Income Securities

Very Short Question Answer

1. State the major features of fixed income securities and describe any one of them.

Fixed income securities have various features such as an issuer, a maturity date, par value, and coupon. Coupon is the stated annual rate of interest that is paid on the par value of fixed income securities. For example, a bond generally has Rs 1,000 par value. If the coupon rate of bond is 8 percent, the issuer of the band pays 8 percent of Rs 1,000 (that is, ks 80 in annual interest per bond).

2. What are the major features of fixed income securities? Describe any one of them.

Fixed income securities have various features such as an issuer, a maturity date, par value, and coupon. Coupon is the stated annual rate of interest that is paid on the par value of fixed income securities. For example, a bond generally has Rs 1,000 par value. If the coupon rate of bond is 8 percent, the issuer of the band pays 8 percent of Rs 1,000 (that is, ks 80 in annual interest per bond).

3. Explain any two features of fixed income securities in brief.

Two popular features of fixed income securities are: constant regular income and maturity. Fixed income securities like bonds and preferred stock give their holders a relatively constant and regular interest and dividend income. Similarly, these securities are issued with a fixed maturity. After the expiry of stated maturity, the holders are paid back the original investment or maturity value.

4. What do you understand by call provision?

 A call provision is the special feature associated with bond and preferred stock issue. This feature allows the issuer to call the bonds and preferred stock for redemption before the expiry of maturity period. The issuer generally calls the bonds and preferred stock for redemption if the market interest rate declines significantly.

5. List out the types of risk associated with bond investment.

There are several types of risk associated with bond investment. They are as follows:

• Credit risk
• Interest rate risk
•  Reinvestment risk
• Liquidity risk
• Call risk
• Purchasing power risk.

Short Question Answer

1. What do you mean by fixed Income securities? Explain the types of money market fixed income securities.

Fixed income securities are those securities which offer the fixed periodic rate of return to the holders. Fixed income securities may be long-term securities such as bonds and preferred stock. Bonds pay fixed rate of periodic interest and preferred stock pay fixed rate of dividend. They are called long-terra securities because they have longer term to maturity of more than one year. They are called capital market fixed income securities. Money market fixed income securities have the term to maturity of less than one year. They are as follows:

• Treasury Bills: Treasury bills are short-term securities issued by government to raise short-term funds. They are sold at a discount from the stated face value. At the expiry of maturity, the holders are paid back the face value. The discount to the investor represents the rate of return investment. T-bills are very liquid and risk-free investment alternatives. In Nepal, T- bills are issued having the maturity of 28 days, 91 days, 182 days, and 364 days. The Treasury bills are sold with minimum Rs 25,000 face value denominations.
• Certificates of Deposit: A certificate of deposit (CD) is a time deposit with a bank. A CD can not be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of fixed maturity which is usually of less than one year. Some CDs are negotiable that they can be traded in the secondary market before the maturity. Such CDs are called negotiable certificate of deposits. The rates of return on CDs are generally higher than the T-bills because of higher risk.
• Eurodollars: Eurodollars are dollar dominated deposits in bank account. outside the U.S.A. For example, the dollars deposited in the Bank of Kathmandu Limited in a dollar-denominated account are called Eurodollars. Only the person having the dollar income can open the dollar accounts in Nepal.
• Repurchase Agreements: Repurchase agreement (Repo) is not a specific security but it represents the collateralized loan. It is an agreement whereby bank or security dealer or other financial institution sells specific marketable securities to a firm and thereby agrees to repurchase them at a higher price in specific time in future. The difference between repurchase price and the original selling price represents the return to investors.

2. What are money market instruments? Explain important types of money market instruments in light of their risk and return characteristics. [4+6]

Money market instruments are short-term fixed income securities that have ‘ess than one year to maturity. Money market instruments mature within one year of issue. Most of money market instruments are high-quality securities. Their risk of default is very low and they are highly liquid. They are generally issued with larger denominations of face value. Most of the money market instruments are sold at discount and the holders are paid back the face value at maturity. The discount represents the return to the holders. Money market instruments are unsecured because they are issued without collateral.

Important Types of Money Market Instruments

• Treasury Bills: Treasury bills are short-term securities issued by government to raise short-term funds. They are sold at a discount from the stated face value. At the expiry of maturity, the holders are paid back the face value. The discount to the investor represents the rate of return investment. T-bills are very liquid and risk-free investment alternatives. In Nepal, T- bills are issued having the maturity of 28 days, 91 days, 182 days, and 364 days. The Treasury bills are sold with minimum Rs 25,000 face value denominations.
• Certificates of Deposit: A certificate of deposit (CD) is a time deposit with a bank. A CD can not be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of fixed maturity which is usually of less than one year. Some CDs are negotiable that they can be traded in the secondary market before the maturity. Such CDs are called negotiable certificate of deposits. The rates of return on CDs are generally higher than the T-bills because of higher risk.
• Eurodollars: Eurodollars are dollar dominated deposits in bank account. outside the U.S.A. For example, the dollars deposited in the Bank of Kathmandu Limited in a dollar-denominated account are called Eurodollars. Only the person having the dollar income can open the dollar accounts in Nepal.
• Repurchase Agreements: Repurchase agreement (Repo) is not a specific security but it represents the collateralized loan. It is an agreement whereby bank or security dealer or other financial institution sells specific marketable securities to a firm and thereby agrees to repurchase them at a higher price in specific time in future. The difference between repurchase price and the original selling price represents the return to investors.

3. What is fixed income security? Briefly describe the types of fixed income securities. [10]

Fixed income securities are those securities whicl: offer the fixed periodic rate of return to the holders. Fixe income securities may be long term securities such as bonds and preferred stock. Bonds pay fixed rate of periodic interest and preferred stock pay fixed rate of dividend. They are called long-term securities because they have longer term : maturity of more than one year. They are called capital market fixed income securities. Money market fixed income securities have the term to maturity of less than one year. Fixed income securities are classified as money market instruments, gomment securities, local government securities, corpcrate bonds, and preferred stock. They are described below:

• Money market instruments: Money market instruments are short-term fixed income securities that have less than one year to maturity. Money market instruments mature within one year of issue. Most of money market instruments are high-quality securities Their risk of default is very low and they are highly liquid. They are generally issued with larger denominations of face value. Most of the money market instruments are sold at discount and the holders are paid back the face value at maturity. The discount represents the return to the holders. Money market instruments are unsecured because they are issued without collateral.
• Government securities: Government issues different types of securities to raise short-term and long-term funds. Important types of government securities are Treasury bills, Treasury notes and Treasury bonds. Treasury bills are short-term securities issued by government to raise short-term funds. They are sold at a discount from the stated ace value. At the expiry of maturity, the holders are paid back the face value. The discount to the investor represents the rate of return on investment. T-bills are very liquid and risk-free investment alternatives. In Nepal, T- bills are issued having the maturity of 28 days, 91 days, 182 days, and 364 days. The Treasury biils are sold with minimum Rs 25,000 face value denominations. Treasury notes and bonds are long-term debt instruments issued by the government. Treasury notes have original maturities of ten years or less while Treasury bonds have original maturity of more than ten years. Treasury notes and bonds have interest rate risk due to longer maturity. They are issued with specific coupon rate. The coupon interest is generally paid every six month. Besides, the Treasury bonds may have call provision as well. Treasury bonds and notes are usually issued with Rs 1,000 or more face value denominations.
• Local government securities: The securities issued by state and local governments are called local government securities or municipal securities. They have longer term to maturity. They are issued to finance local developmental activities. Interests aidratmcipa bonds are fully tax exempted. The municipal bonds may be classified as general obligation bonds  and revenue bonds A genera obligation bond is a debt instrument tha s backed by the full faith and the credit of the government unit that issues them. Revenue bonds are used to finance revenue producing projects and income generated by the projects such as toll bridge, sport facilities may be used to par bondholders.
• Corporate bonds: A corporate bond is a negotiable, long-term debt instrument issued by corporations. It pays fixed interest for a specified time interval on specified date and repays the principal on maturity to the hond holders. Specified time interval may be quarterly, or semiannually or Corporate bonds are risky as compared to the Treasury bonds because corporations are likely to detault. The holders of corporate bond do not get ownership rights and privileges because they are only lenders to the They are paid maturity value upon the maturity of bonds. company. annually.
• Preferred stock: A preferred stock is long-term fixed income security. It is a hybrid form of financing with combined features of both bond and commor stock. Like common stock, preferred stock is legally considered as ownership capitai, nonpayment of preference dividends does not force the corapany ituc bankruptcy and dividend is paid out of after-tax profit. On the other hand, like bonds, preferred stock has a par value, preferred stock dividends are fixed in amount and generally, preferred stockholders have no voting right. Often, preferred stocks carry credit ratings much like those of bonds and preferred stocks are often callable.

4. Briefly describe the types of short-term fixed income securities available in Nepal?

Fixed income securities are those securities which offer the fixed periodic rate of return to the holders. Fixed income securities may be long-term securities such as bonds and preferred stock. Bonds pay fixed rate of periodic interest and preferred stock pay fixed rate of dividend. They are called long-terra securities because they have longer term to maturity of more than one year. They are called capital market fixed income securities. Money market fixed income securities have the term to maturity of less than one year. They are as follows:

• Treasury Bills: Treasury bills are short-term securities issued by government to raise short-term funds. They are sold at a discount from the stated face value. At the expiry of maturity, the holders are paid back the face value. The discount to the investor represents the rate of return investment. T-bills are very liquid and risk-free investment alternatives. In Nepal, T- bills are issued having the maturity of 28 days, 91 days, 182 days, and 364 days. The Treasury bills are sold with minimum Rs 25,000 face value denominations.
• Certificates of Deposit: A certificate of deposit (CD) is a time deposit with a bank. A CD can not be withdrawn on demand. The bank pays interest and principal to the depositor only at the end of fixed maturity which is usually of less than one year. Some CDs are negotiable that they can be traded in the secondary market before the maturity. Such CDs are called negotiable certificate of deposits. The rates of return on CDs are generally higher than the T-bills because of higher risk.
• Eurodollars: Eurodollars are dollar dominated deposits in bank account. outside the U.S.A. For example, the dollars deposited in the Bank of Kathmandu Limited in a dollar-denominated account are called Eurodollars. Only the person having the dollar income can open the dollar accounts in Nepal.
• Repurchase Agreements: Repurchase agreement (Repo) is not a specific security but it represents the collateralized loan. It is an agreement whereby bank or security dealer or other financial institution sells specific marketable securities to a firm and thereby agrees to repurchase them at a higher price in specific time in future. The difference between repurchase price and the original selling price represents the return to investors.

5. NUMERICAL PROBLEMS

Long Question Answer

2. Consider the following quote from the Economic bulletin on a corporate bond traded on the NEPSE.

3. Consider the following quotation:

Rate	Maturity	Bid	Ask	Change	Ask yield
6	Ashad 070n	108:04	108:07	-9	5:47

• What does ‘Ashad 0,70n indicates? Explain its value to investors.
• What is the coupon rate and do you think that it is based on the market interest rate?
• At what price could it be sold to and purchase from a dealer?
• What does the change +9 mean? v. What does the ask yield of 5 47 mean?

SOLUTION

2070. Ashad 070n’ indicates that the note matures in Ashad 2070. It is important to to identify the remaining maturity of the bond so as to match the investment horizon
2071. The coupon rate of note is 6 percent. It is always determined on the basis of prevailing market interest rate at the time of issue. However, after the issue market interest rate may change over the same. years while coupon rate stays the
2072. The quoted bond could be sold to a dealer at 108 04/32 percent of par value. That is, Bid price = 108.125% of Rs 1,000 = Rs 1,081.25 The quoted bond could be purchased from the dealer for 108 07/32 percent of par value That is, Ask price = Rs 1,08.21875% of Rs 1,000 = Rs 1,082.8175.
2073. The change of +9 indicates that the bid price was 9/32 percent of Rs 1,000 (i.e. Rs 2.8125) more than it had been on the previous trading day.
2074. Ask yield of 5.47 means that the effective yield to maturity at the time based on. the asked price was approximately 5.47 percent.

4. Assume you are considering buying a Rs 10,000 face value, 90 days Treasury bill, issued today by Nepal Rastra Bank. The bill is selling for Rs 9,675.

• What is the annual discount based on the selling price of the bill?
• What is the annual equivalent yield of the bill?

SOLUTION

Given:

5.Information are given below