Month: May 2020

Government bonds: The government bond sector is a broad category that includes “sovereign” debt, which is issued and generally backed by a central government. Government of Canada Bonds (GoCs), U.K. Gilts, U.S. Treasuries, German Bunds, Japanese Government Bonds (JGBs) and Brazilian Government Bonds, Indian govt. bonds are all examples of sovereign government bonds. The U.S., Japan and Europe have historically been the biggest issuers in the government bond market.

A number of governments also issue sovereign bonds that are linked to inflation, known as inflation-linked bonds or, in the U.S., Treasury Inflation-Protected Securities (TIPS). On an inflation-linked bond, the interest and/or principal is adjusted on a regular basis to reflect changes in the rate of inflation, thus providing a “real,” or inflation-adjusted, return. But, unlike other bonds, inflation-linked bonds could experience greater losses when real interest rates are moving faster than nominal interest rates.

In addition to sovereign bonds, the government bond sector includes subcomponents, such as:

• Agency and “quasi-government” bonds: Central governments pursue various goals supporting affordable housing or the development of small businesses, for example through agencies, a number of which issue bonds to support their operations. Some agency bonds are guaranteed by the central government while others are not. Supranational organizations, like the World Bank and the European Investment Bank, also borrow in the bond market to finance public projects and/or development.
• Local government bonds: Local governments whether provinces, states or cities borrow to finance a variety of projects, from bridges to schools, as well as general operations. The market for local government bonds is well established in the U.S., where these bonds are known as municipal bonds. Other developed markets also issue provincial/local government bonds.

Corporate bonds: After the government sector, corporate bonds have historically been the largest segment of the bond market. Corporations borrow money in the bond market to expand operations or fund new business ventures. The corporate sector is evolving rapidly, particularly in Europe and many developing countries.

Corporate bonds fall into two broad categories: investment grade and speculative-grade (also known as high yield or “junk”) bonds. Speculative-grade bonds are issued by companies perceived to have lower credit quality and higher default risk than more highly rated, investment grade companies. Within these two broad categories, corporate bonds have a wide range of ratings, reflecting the fact that the financial health of issuers can vary significantly.

Speculative-grade bonds tend to be issued by newer companies, companies in particularly competitive or volatile sectors, or companies with troubling fundamentals. While a speculative-grade credit rating indicates a higher default probability, higher coupons on these bonds aim to compensate investors for the higher risk. Ratings can be downgraded if the credit quality of the issuer deteriorates or upgraded if fundamentals improve.

The Security Printing & Minting Corporation of India Ltd. (SPMCIL) is a Mini-Ratna Central Public Sector Enterprise (CPSE). It is a wholly owned by Government of India Schedule “A” Company of the Government of India and was incorporated on 13 January 2006 with its registered office at New Delhi. The Corporation is engaged in the manufacture / production of Currency and Bank Notes, Security Paper, Non-judicial Stamp Papers, Postal Stamps & Stationery, Travel Documents viz., Passport and Visa, Security Certificates, Cheques, Bonds, Warrants, Special Certificates with Security Features, Security Inks, Circulation & Commemorative Coins, Medallions, Refining of Gold, Silver and Assay of Precious Metals, etc.

The company was formed in 2006 as the result of corporatisation of security presses and mints functioning under the Indian Ministry of Finance. It contains nine units, four mints, four presses and a paper mill.

Organisation structure

SPMCIL organisational sturcute

Corporate Structure of SPMCIL

SPMCIL is headed by a board of directors, presided by the chairman and managing director. The other board members include three functional directors who head the departments of technology, finance and human resource. Apart from the four functional directors, two independent directors are nominated by the Ministry of Finance and one by the Ministry of External Affairs. The board also commissions a Chief Vigilance Officer (CVO) who heads the organisation’s internal vigilance department. His functional responsibilities include managing production planning, maintenance, technology, R&D, logistics, procurement and marketing. Every individual unit is headed by a Chief General Manager who functions under the control and directions of the head office.

Finance Department

The finance department handles accounts, taxation, internal audits, costing, budgeting, capital investments corporate finance, co-ordination with auditors, systems and co-ordination, company secretariat etc.

Human Resource

The human resource department handles administration, establishment, legal matters, training, personnel and industry relations.

Units

According to the information made available, SPMCIL broadly operates through four production verticals i.e. currency printing presses, security printing presses, security paper mill and India Government mints.

Currency Printing Presses

SPMCIL consists of two currency printing presses: The Currency Note Press (CNP) in Nashik and the Bank Note Press (BNP) in Dewas. The two units are engaged in production of bank notes for India as well as a few foreign countries including Iraq, Nepal, Sri Lanka, Myanmar and Bhutan. More than 40% of Currency Notes circulated in India are printed by the two units. These units are equipped with designing, engraving, complete Pre-printing and Offset facilities, Intaglio Printing machines, Numbering & Finishing machines etc.

The CNP was established in 1928 as the first printing press for bank notes in India. They are currently responsible for the printing of the new 500 rupee notes following the demonetisation of the old 500 rupee and 1000 rupee note. Currency is also printed by the two presses of Bharatiya Reserve Bank Note Mudran Private Limited, a wholly owned subsidiary of Reserve Bank of India. They are currently responsible for the printing of the new 2000 rupee notes, and speculations suggest that the printing of the 500 rupee notes will also shift to these presses for better speed and fewer errors. BNP also has an ink factory that produces ink for security printing.

Security Printing Presses

There are two Security printing presses of SPMCIL, namely the India Security Press (ISP) at Nashik and Security Printing Press (SPP) at Hyderabad. These presses print the 100% requirement of passports and other travel documents, non-judicial stamp papers, cheques, bonds, warrants, postal stamps and postal stationery and other security products. The Security Printing Presses have the capability of incorporating security features like chemically reactive elements, various Guilloche patterns, micro lettering, designs with UV inks, bi-fluorescent inks, optical variable inks, micro perforation, adhesive/glue, embossing, die-cutting and personalization, etc.

Mints

SPMCIL comprises four units of India Government Mint located in the cities of Mumbai, Kolkata, Hyderabad and Noida.[9] These mints produce circulation coins, commemorative coins, medallions and bullion, as required by the Government of India.

Paper mill

Security Paper Mill was established in 1968 at Hoshangabad, Madhya Pradesh. It produces papers for banknotes and non–judicial stamps and further prints with new enhanced unit.

1. Serial Bonds:

Serial bonds are issued by an organization with different maturity dates. This is done to enable the company to retire the bonds in instalments rather than all together. It is less likely to disturb the cash position of the firm than if all the bonds were retired together.

From the point of view of the bondholder, this gives him a chance to select a bond of the maturity date which would suit his portfolio. He may select a short-term maturity bond if it meets his need or take a bond with a long-term maturity if he already has too many shorter-term investments.

Serial bonds usually do not have the call feature and the company retires the debt when it becomes payable on the maturity date. Such bonds are useful to those companies that wish to retire their bonds in series. Serial bonds, resemble sinking fund bonds and have an effect on the yields of bonds. Bonds with shorter-term maturity have lower yields compared to those of long- term maturities.

2. Sinking Fund Bonds:

Sometimes, an organization plans the issue of its bonds in such a way that there is no burden on the company at the time of retiring bonds. This has the advantage of using the funds are well as retiring them without any excessive liquidity problems.

The company sets apart an amount annually for retirement of bonds. The annual installment is usually fixed and put in a sinking fund through the trustees. The trustee uses his discretion in investing these funds. He may use the fund to call the bonds every year or purchase bonds from them at a discount. Sinking fund bonds are commonly used as a measure of industrial financing.

3. Registered Bonds:

Registered bonds offer an additional security by a safety value, attached to them. A registered bond protects the owner from loss of principal. The bondholder’s bond numbers, name address and type of bond are entered in the register of the issuing company. The bondholder has to comply with the firm’s formalities at the time of transfer of bonds.

While receiving interest, registered bondholders usually get their payment by cheque. The main advantage of registering a bond is that if the bond is misplaced or lost, the bondholder does not suffer a loss unlike the unregistered bonds. However, registered bonds do not offer security of principal at maturity.

4. Debenture Bonds:

Debentures in the USA are considered to be slightly different from bonds. Debenture bonds are issued by those companies who have an excellent credit rating but do not have security in the form of assets to pledge to the bondholders. The debenture holders are creditors of the firm and receive the full rate of interest whether the company makes a profit or not.

In India, debentures can be issued with the specific permission of the Controller of Capital Issues. Bearer debentures are not considered legal and permissible documents in India. Convertible debentures have become popular in recent years.

Convertible debentures have lower rates of interest but the convertible clause makes it an attractive investment. While permission has to be sought for the convertibility clause, it is not necessary if they are solely offered to financial institutions. Debentures can be of different kinds. They may be registered, convertible, mortgage, guaranteed and may also combine more than one feature in one issue.

5. Mortgage Bonds:

A mortgage bond is a promise by the bond issuing authority to pledge real property as additional security. If the company does not pay its bondholders the interest or the principal, when it falls due, the bondholders have the right to sell the security and get back their dues.

The value of mortgage bonds depends on the quality of property mortgages and the kind of charge on property. A first charge is the most suitable and highly secure form of investment, since its claims will be on priority of the asset.

A specific claim on a particular property is also an important consideration compared to a general charge. A second and third charge on security of property is considered to be a weak form of security, and is less sound than a first charge. Sometimes, however, second or third charges prove useful when the quality of the property with a first charge is poor.

This means that a property which is of high value and immediately saleable because of its strategic placement should be considered very valuable even if it offers a second and third charge.

Another property offering no saleable features but giving a first charge may be worthless to the bondholders. The quality of the mortgage is, therefore, an important consideration to the mortgage bondholders. Mortgage bonds may be open end, close end and limited open end.

An open end mortgage bond permits the bond issuing company to issue additional bonds if earnings and asset coverage make it permissible to do so. In close end mortgage bonds, the company can make only one issue of bonds and while those bonds exist, new bonds cannot be issued.

If additional bonds are issued they get the ranking of junior bonds and the prior issue gets the first priority in receiving payments. The limited open end bonds permit the organization to issue specified number of fresh bonds series distributed over a number of years.

6. Collateral Trust Bonds:

A collateral trust bond is issued generally when two companies exist and are in the relationship of parent and subsidiary. The collateral that is provided in these bonds is the personal property of the company which issues the bonds. A typical example of such bonds is when a parent company requires funds, it issues collateral bonds by pledging securities of its own subsidiary company.

The collaterals are generally in the form of intangible securities like shares or bonds. These bonds have a priority charge on the shares or bonds which are used as collaterals. The quality of the collateral bonds is determined by the assets and earning position of both the parent as well as the subsidiary company.

7. Equipment Trust Bonds:

In the USA, a typical example of Equipment Trust Bonds is the issue of bonds with equipment like machinery as security. The property papers are submitted to trustees. These bonds are retired serially.

The usual method of using these bonds was to issue 20% equity and 80% bonds. The equity issue is like a reverse to protect the lender in cases where the value of the asset falls in the market. The trustee also has the right to sell the equipment and pay the bondholders in case of default.

8. Supplemental Credit Bonds:

When additional pledge is guaranteed to the bondholders their bonds are categorized as supplemental by an additional non-specific guarantee. Such bonds are classified as: Guaranteed Bonds, Joint Bonds and Assumed Bonds.

9. Guaranteed Bonds:

Guaranteed Bonds are issued as bonds secured by the issuing company and they are guaranteed by another company. Sometimes, a company takes assets through a lease. The leasing company guarantees the bonds of the bond issuing company regarding interest and principal amount due on bonds.

10. Joint Bonds:

Joint bonds are guaranteed bonds secured jointly by two or more companies. These bonds are issued when two or more companies are in need of finance and decide to raise the funds together through bonds. It serves the purpose of the company as well as the investor.

The company raises funds at reduced cost. Since funds are raised jointly, dual operations of advertising and the formalities of capital issues control are avoided. The investor is in a favourable position as he has security by pledge of two organizations.

11. Assumed Bonds:

These bonds are the result of a decision between two companies to amalgamate or merge together. For example, Company-X decides to merge into Company-Y. X’s issue of bonds prior to merger then becomes the obligation of Company-Y when merger is effected.

These are called assumed bonds as Company-Y did not originally issue them but as a result of merger the debt was passed on to them. The bondholder receives an additional pledge from Company-Y. He is more secured as his bonds due to merger get the safety of both Companies X and Y.

12. Income Bonds:

Such bonds offer interest to the bondholders only when the firm earns a profit. If profit is not declared in a particular year, interest on bonds is cumulated for a future period when the company can sufficiently earn and make a profit.

Income bonds are frequently issued in case of reorganization of companies. When income bonds arise out of reorganization they are called adjustment bonds. They are also used to recapitalize the firm and take the benefit of deduction of tax by changing preference shares with income bonds.

13. Bonds with Warrants:

Bonds with warrants are also called Warrant Bonds. Each bond has one warrant attached to it and it gives the right to the bondholder to pay a subscription price and exchange the bonds for equity shares. This right is given, for a limited period of time. Usually, a time period is put up in a legal document with the trustee.

Warrant bonds may be detachable or non-detachable. Detachable warrants are used by the investor (a) to sell the warrant during price increase in the market, and (b) to buy stock at an option price and to be sold at market value. A non-detachable bond is slightly more complicated. It has to be sent to the company’s trustee at the time of exercising an option. The warrant is detached by the trustee and sent to the investor.

Warrant bonds like convertible bonds offer a chance to the investor to share in the growth of the company, but convertible bonds are more popular than warrant bonds.

In India, convertible debenture bonds are also relatively new and not as popular as equity issues. The warrant bond gives the right to its holder to sell a warrant if the price increases in the market and retain the bond. If the price does not increase, the bondholder may retain the bond with a warrant.

14. Foreign Bonds:

Bonds raised in India by foreign companies but for Indian investor will he called a ‘foreign bond’. A foreign bond, for example, an American Bond or Japanese Bond in India may be very attractive to investors because (a) the dollar yield is much higher than the rupee, (b) deposits in dollars are considered a good investment, and (c) risk on the portfolio is diversified.

Having described the different kinds of bonds, let us find out the objective of issuing such bonds as well as evaluate bonds as an investment.

Debt investments and equity investments recorded using the cost method are classified as trading securities, available‐for‐sale securities, or, in the case of debt investments, held‐to‐maturity securities. The classification is based on the intent of the company as to the length of time it will hold each investment. A debt investment classified as held‐to‐maturity means the business has the intent and ability to hold the bond until it matures. The balance sheet classification of these investments as short‐term (current) or long‐term is based on their maturity dates.

Debt and equity investments classified as trading securities are those which were bought for the purpose of selling them within a short time of their purchase. These investments are considered short‐term assets and are revalued at each balance sheet date to their current fair market value. Any gains or losses due to changes in fair market value during the period are reported as gains or losses on the income statement because, by definition, a trading security will be sold in the near future at its market value. In recording the gains and losses on trading securities, a valuation account is used to hold the adjustment for the gains and losses so when each investment is sold, the actual gain or loss can be determined. The valuation account is used to adjust the value in the trading securities account reported on the balance sheet.

Debt and equity investments that are not classified as trading securities or held‐to‐maturity securities are called available‐for‐sale securities. Whereas trading securities are short‐term, available‐for‐sale securities may be classified as either short‐term or long‐term assets based on management’s intention of when to sell the securities. Available‐for‐sale securities are also valued at fair market value. Any resulting gain or loss is recorded to an unrealized gain and loss account that is reported as a separate line item in the stockholders’ equity section of the balance sheet. The gains and losses for available‐for‐sale securities are not reported on the income statement until the securities are sold. Unlike trading securities that will be sold in the near future, there is a longer time before available‐for‐sale securities will be sold, and therefore, greater potential exists for changes in the fair market value.

When valuing a company as a going concern, there are three main valuation methods used by industry practitioners:

(1) DCF analysis

(2) comparable company analysis,

(3) precedent transactions.

These are the most common methods of valuation used in investment banking, equity research, private equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts (LBO), and most areas of finance.

As shown in the diagram above, when valuing a business or asset, there are three broad categories that each contain their own methods. The Cost Approach looks at what it costs to build something and this method is not frequently used by finance professionals to value a company as a going concern. Next is the Market Approach, this is a form of relative valuation and frequently used in the industry. It includes Comparable Analysis Precedent Transactions.  Finally, the discounted cash flow (DCF) approach is a form of intrinsic valuation and is the most detailed and thorough approach to valuation modeling.

Method 1: Comparable Analysis (“Comps”)

Comparable company analysis (also called “trading multiples” or “peer group analysis” or “equity comps” or “public market multiples”) is a relative valuation method in which you compare the current value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or other ratios. Multiples of EBITDA are the most common valuation method.

The “comps” valuation method provides an observable value for the business, based on what companies are currently worth. Comps are the most widely used approach, as they are easy to calculate and always current.

Method 2: Precedent Transactions

Precedent transactions analysis is another form of relative valuation where you compare the company in question to other businesses that have recently been sold or acquired in the same industry. These transaction values include the take-over premium included in the price for which they were acquired.

These values represent the en bloc value of a business. They are useful for M&A transactions, but can easily become stale-dated and no longer reflective of the current market as time passes. They are less commonly used than Comps or market trading multiples.

Method 3: DCF Analysis

Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst forecasts the business’ unlevered free cash flow into the future and discounts it back to today at the firm’s Weighted Average Cost of Captial (WACC).

A DCF analysis is performed by building a financial model in Excel and requires an extensive amount of detail and analysis.  It is the most detailed of the three approaches, requires the most assumptions, and often produces the highest value. However, the effort required for preparing a DCF model will also often result in the most accurate valuation. A DCF model allows the analyst to forecast value based on different scenarios, and even perform a sensitivity analysis.

For larger businesses, the DCF value is commonly a sum-of-the-parts analysis, where different business units are modeled individually and added together.

The inverse relationship between the interest rate and bond prices can be explained by opportunity risk. By purchasing bonds, an investor assumes that if the interest rate increases, he or she will give up the opportunity of purchasing the bonds with more attractive returns. Whenever the interest rate increases, the demand for existing bonds with lower returns declines as new investment opportunities arise (e.g., new bonds with higher return rates are issued).

Although the prices of all bonds are affected by interest rate fluctuations, the magnitude of the change varies among bonds. Different bonds show different price sensitivities to interest rate fluctuations. Thus, it is imperative to evaluate a bond’s duration while assessing the interest rate risk.

Generally, bonds with a shorter time to maturity carry a smaller interest rate risk compared to bonds with longer maturities. Long-term bonds imply a higher probability of interest rate changes. Therefore, they carry a higher interest rate risk.

How to Mitigate Interest Rate Risk?

Similar to other types of risks, the interest rate risk can be mitigated. The most common tools for interest rate mitigation include:

1. Diversification

If a bondholder is afraid of interest rate risk that can negatively affect the value of his portfolio, he can diversify his existing portfolio by adding securities whose value is less prone to the interest rate fluctuations (e.g., equity). If the investor has a “bonds only” portfolio, he can diversify the portfolio by including a mix of short-term and long-term bonds.

2. Hedging

The interest rate risk can also be mitigated through various hedging strategies. These strategies generally include the purchase of different types of derivatives. The most common examples include interest rate swaps, options, futures, and forward rate agreements (FRAs).

Types of Interest Rate Risks

There are quite a few types of interest rate risks, which must be noted by every investor, be it an individual or a firm. These are explained below in detail.

• Price risk

The risk of change in the price of an investment bond or certificate is known as its price risk. This leads to unforeseen loss or gains while selling security in the future.

• Reinvestment risk

The risk of change in their interest rate might lead to the selling of the securities. In turn, this can lead to a loss of opportunity to re-invest in the current interest rate. Known as reinvestment risk, these types of interest rate risk can be further divided into 2 categories.

Factors Impacting Interest Rate Risks of a Firm

There are many factors, which directly impact the interest rate risk associated with a company. These factors are discussed below in detail.

• Credit risk associated with a company: A company’s debt to equity ratio is one of the primary determinants of credit risk. A rise in interest rates leads to more expense for a company since they have to pay more interest to its investors. As a result, the credit risk of an institution increases.

• Length of loan terms: Length of loan terms, both as a borrower as well as a lender, are major determinants of the interest rate risks of an institution. Companies and ventures charging a fixed interest on its receivable accounts might have baselines dropping down if they need to refinance themselves. This, in turn, increases the risk involved with the shift in interest rates.

• Market fluctuation: Market fluctuation and inflation can immensely impact the risk related to interest rates since refinancing, or other such necessities can become more difficult during such times. Such circumstances often lead to a situation where outgoing cash flow crosses the incoming cash flow, making it more difficult for the institution to function.

• Foreign exchange rates: Any company which has a foreign debt is also affected by a change in foreign exchange rates. The associated interest rate risks increase with fall in the price of the prevalent currency, while the inverse happens in case there is a rise in the price of the currency.

Manage Interest Rate Risks

It is important to learn how to manage interest rate risk since it can potentially make an institution dysfunctional and ultimately bankrupt. The few methods which can be employed to manage the interest rate and in turn associated risks are discussed below.

• Diversification: Among the different options that can be employed by an institution to manage the interest rate risk associated with them, one of the most effective options is to diversify their financial investments. For investors who invest in both equity and fixed investment options, this is the best method to manage the risks associated with interest rates.

• Safer investments: The safest option for investors who are trying to reduce the risks associated with interest rates is to invest in bonds and certificates, which have short maturity tenure. Securities with short maturity tenure are less susceptible to the fluctuations in interest rate. This method for interest rate management reduces the chance of being subjected to interest rate fluctuations since they have low maturity tenure.

• Hedging: Hedging is an option, which can be used successfully to reduce the risks related to interest rates. Generally referring to the purchase of various types of derivatives which are available, there are many ways of hedging. A few of the hedging strategies are illustrated in the table below.

• Selling long-term bonds: A common method which is often used is that of selling the long-term bonds. This effectively clears up the investment funds for re-investment in bonds with higher returns, thus allowing investors to manage the interest rate risk better. It is advisable to re-invest in securities which have shorter maturity tenure since these carry lesser risks related to interest rates.

• Purchasing floating-rate bonds: Floating rate bonds, as suggested by its name, have a rate of interest, which is directly related to market fluctuations. It is advisable to invest in these securities since being related to the market fluctuations, the return on these investments go up and down too. These should also be bought in a healthy mix of long-term and short-term investments. While this cannot always be used to calculate the exact return, it is helpful in reducing the interest rate risk involved.

It is important for investors to note the above risk management options since risks related to interest rates can greatly affect a company or an investor. Evident from the interest rate risk example mentioned above in this article, managing the risk is necessary to prevent the devaluation of any investment security.

The Dividend Discount Model (DDM) is a quantitative method of valuing a company’s stock price based on the assumption that the current fair price of a stock equals the sum of all company’s future dividends discounted back to their present value.

The dividend discount model was developed under the assumption that the intrinsic value of a stock reflects the present value of all future cash flows generated by a security. At the same time, dividends are essentially the positive cash flows generated by a company and distributed to the shareholders.

Generally, the dividend discount model provides an easy way to calculate a fair stock price from a mathematical perspective with minimum input variables required. However, the model relies on several assumptions that cannot be easily forecasted.

Depending on the variation of the dividend discount model, an analyst requires forecasting future dividend payments, the growth of dividend payments, and the cost of equity capital. Forecasting all the variables precisely is almost impossible. Thus, in many cases, the theoretical fair stock price is far from reality.

1. Gordon Growth Model (Costant)

The Gordon Growth Model (GGM) is one of the most commonly used variations of the dividend discount model. The model is called after American economist Myron J. Gordon, who proposed the variation.

The GGM is based on the assumptions that the stream of future dividends will grow at some constant rate in future for an infinite time. Mathematically, the model is expressed in the following way:

Where:

• V₀ – the current fair value of a stock
• D₁ – the dividend payment in one period from now
• r – the estimated cost of equity capital (usually calculated using CAPM)
• g – the constant growth rate of the company’s dividends for an infinite time

2. One-period Dividend Discount Model

The one-period discount dividend model is used much less frequently than the Gordon Growth model. The former is applied when an investor wants to determine the intrinsic price of a stock that he or she will sell in one period from now. The one-period dividend discount model uses the following equation:

Where:

• V₀ – the current fair value of a stock
• D₁ – the dividend payment in one period from now
• P₁ – the stock price in one period from now
• r – the estimated cost of equity capital

3. Multi-period Dividend Discount Model

The multi-period dividend discount model is an extension of the one-period dividend discount model wherein an investor expects to hold a stock for the multiple periods. The main challenge of the multi-period model variation is that forecasting dividend payments for different periods is required. The model’s mathematical formula is below:

Interest rate risk is the potential for investment losses that result from a change in interest rates. If interest rates rise, for instance, the value of a bond or other fixed-income investment will decline. The change in a bond’s price given a change in interest rates is known as its duration.

Interest rate risk can be reduced by holding bonds of different durations, and investors may also allay interest rate risk by hedging fixed-income investments with interest rate swaps, options, or other interest rate derivatives.

• Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investment:
• As interest rates rise bond prices fall, and vice versa. This means that the market price of existing bonds drops to offset the more attractive rates of new bond issues.
• Interest rate risk is measured by a fixed income security’s duration, with longer-term bonds having a greater price sensitivity to rate changes.
• Interest rate risk can be reduced through diversification of bond maturities or hedged using interest rate derivatives.

Interest rate changes can affect many investments, but it impacts the value of bonds and other fixed-income securities most directly. Bondholders, therefore, carefully monitor interest rates and make decisions based on how interest rates are perceived to change over time.

For fixed-income securities, as interest rates rise security prices fall (and vice versa). This is because when interest rates increase, the opportunity cost of holding those bonds increases that is, the cost of missing out on an even better investment is greater. The rates earned on bonds therefore have less appeal as rates rise, so if a bond paying a fixed rate of 5% is trading at its par value of $1,000 when prevailing interest rates are also at 5%, it becomes far less attractive to earn that same 5% when rates elsewhere start to rise to say 6% or 7%. In order to compensate for this economic disadvantage in the market, the value of these bonds must fall – because who will want to own a 5% interest rate when they can get 7% with some different bond.

Therefore, for bonds that have a fixed rate, when interest rates rise to a point above that fixed level, investors switch to investments that reflect the higher interest rate. Securities that were issued before the interest rate change can compete with new issues only by dropping their prices.

Interest rate risk can be managed through hedging or diversification strategies that reduce a portfolio’s effective duration or negate the effect of rate changes.

The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price and earnings per share (EPS). It is a popular ratio that gives investors a better sense of the value of the company. The P/E ratio shows the expectations of the market and is the price you must pay per unit of current earnings (or future earnings, as the case may be).

Earnings are important when valuing a company’s stock because investors want to know how profitable a company is and how profitable it will be in the future. Furthermore, if the company doesn’t grow and the current level of earnings remains constant, the P/E can be interpreted as the number of years it will take for the company to pay back the amount paid for each share.

P/E Ratio in Use

Looking at the P/E of a stock tells you very little about it if it’s not compared to the company’s historical P/E or the competitor’s P/E from the same industry. It’s not easy to conclude whether a stock with a P/E of 10x is a bargain, or a P/E of 50x is expensive without performing any comparisons.

The beauty of the P/E ratio is that it standardizes stocks of different prices and earnings levels.

The P/E is also called earnings multiple. There are two types of P/E: trailing and forward. The former is based on previous periods of earnings per share, while a leading or forward P/E ratio is when EPS calculations are based on future estimates, which predicted numbers (often provided by management or equity research analysts).

Price Earnings Ratio Formula

P/E = Stock Price Per Share / Earnings Per Share

or

P/E = Market Capitalization / Total Net Earnings

or

Justified P/E = Dividend Payout Ratio / R – G

where;

R = Required Rate of Return

G = Sustainable Growth Rate

Why Use the Price Earnings Ratio?

Investors want to buy financially sound companies that offer a good return on investment (ROI). Among the many ratios, the P/E is part of the research process for selecting stocks, because we can figure out whether we are paying a fair price. Similar companies within the same industry are grouped together for comparison, regardless of the varying stock prices.  Moreover, it’s quick and easy to use when we’re trying to value a company using earnings. When a high or a low P/E is found, we can quickly assess what kind of stock or company we are dealing with.

High P/E

Companies with a high Price Earnings Ratio are often considered to be growth stocks. This indicates a positive future performance, and investors have higher expectations for future earnings growth and are willing to pay more for them. The downside to this is that growth stocks are often higher in volatility and this puts a lot of pressure on companies to do more to justify their higher valuation. For this reason, investing in growth stocks will more likely be seen as a risky investment. Stocks with high P/E ratios can also be considered overvalued.

Low P/E

Companies with a low Price Earnings Ratio are often considered to be value stocks. It means they are undervalued because their stock price trade lower relative to its fundamentals. This mispricing will be a great bargain and will prompt investors to buy the stock before the market corrects it. And when it does, investors make a profit as a result of a higher stock price. Examples of low P/E stocks can be found in mature industries that pay a steady rate of dividends.

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but it is expressed as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate.

Because yield to maturity is the interest rate an investor would earn by reinvesting every coupon payment from the bond at a constant interest rate until the bond’s maturity date, the present value of all the future cash flows equals the bond’s market price. An investor knows the current bond price, its coupon payments and its maturity value, but the discount rate cannot be calculated directly. However, there is a trial-and-error method for finding YTM with the following present value formula:

Alternative formula for finding YTM

Each one of the future cash flows of the bond is known and because the bond’s current price is also known, a trial-and-error process can be applied to the YTM variable in the equation until the present value of the stream of payments equals the bond’s price.

Solving the equation by hand requires an understanding of the relationship between a bond’s price and its yield, as well as of the different types of bond pricings. Bonds can be priced at a discount, at par or at a premium. When the bond is priced at par, the bond’s interest rate is equal to its coupon rate. A bond priced above par, called a premium bond, has a coupon rate higher than the realized interest rate and a bond priced below par, called a discount bond, has a coupon rate lower than the realized interest rate. If an investor were calculating YTM on a bond priced below par, he or she would solve the equation by plugging in various annual interest rates that were higher than the coupon rate until finding a bond price close to the price of the bond in question.

Calculations of yield to maturity (YTM) assume that all coupon payments are reinvested at the same rate as the bond’s current yield and take into account the bond’s current market price, par value, coupon interest rate and term to maturity. The YTM is merely a snapshot of the return on a bond because coupon payments cannot always be reinvested at the same interest rate. As interest rates rise, the YTM will increase; as interest rates fall, the YTM will decrease.