A project report on bond portfolio management with referance to state bank of india

BONDSJust as people need money, so do companies and governments. A company needs funds to expand into new markets, while governments need money for everything from infrastructure to social programs. The problem large organizations run into is that they typically need far more money than the average bank can provide. The solution is to raise money by issuing bonds (or other debt instruments) to a public market. Thousands of investors then each lend a portion of the capital needed. A bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor..For example, say an investor buys a bond with a face value of Rs 1,000, a coupon of 8%, and a maturity of 10 years. This means the investor receives a total of Rs 80 (Rs 1,000 * 8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, the investor receives two payments of Rs 40 a year for 10 years. When the bond matures after a decade, the investor gets your Rs 1,000 back.The different types of bonds include government securities, corporate bonds, commercial paper, treasury bills, strips etc. These bonds are either fixed interest bonds or floating rate bonds. In fixed interest bonds, the interest component remains the same throughout the tenure of the security. Say a 10-year bond issed today bears 8% interest. Even if 5 years hence, the interest rate in the economy goes down to 5%, this 8% bond will continue to earn the investor 8% interest. In a floating rate bond, the interest rate varies depending on the interst rate of a security that the bond chooses to benchmark it's interest rate to.Bond definition :Bonds are debt and are issued for a period of more than one year. The US government, local governments, water districts, companies and many other types of institutions sell bonds. When an investor buys bonds, he or she is lending money. The seller of the bond agrees to repay the principal amount of the loan at a specified time. Interest-bearing bonds pay interest periodically.TYPES OF BONDSBonds have many characteristics such as the way they pay their interest, the market they are issued in, the currency they are payable in, protective features and their legal status. Bond issuers may be governments, corporations, special purpose trusts or even non-profit organizations. Usually it is the type of issuer or the particular nature of a bond that sets it apart in its own category. We briefly discuss some of the main types of bonds below:THERE ARE MANY TYPES OF BONDS FROM MANY DIFFERENT ISSUERS.ASSET-BACKED SECURITIESGOVERNMENT BONDSCONVERTIBLE BONDSHIGH YIELD OR quot;
JUNKquot;
BONDSCORPORATE BONDSINFLATION-LINKED BONDSEUROBONDSRETRACTABLE BONDSFOREIGNCURRENCY BONDSZERO COUPON OR quot;
STRIPquot;
BONDSASSET-BACKED SECURITIESAsset-backed securities are bonds that are based on underlying pools of assets. A special purpose trust or instrument is set up which takes title to the assets and the cash flows are quot;
passed throughquot;
to the investors in the form of an asset-backed security. The types of assets that can be quot;
securitizedquot;
range from residential mortgages to credit card receivables.All asset-backed securities are securities which are based on pools of underlying assets. These assets are usually illiquid and private in nature. A securitization occurs to make these assets available for investment to a much broader range of investors. The quot;
poolingquot;
of assets occurs to make the securitization large enough to be economical and to diversify the qualities of the underlying assets.Government bondsSupranational AgenciesA supranational agency, such as the World Bank, levies assessments or fees against its member governments. Ultimately, it is this support and the taxation power of the underlying national governments that allow these organizations to make payments on their debts.National GovernmentsThe quot;
centralquot;
or national governments also have the power to print money to pay their debts, as they control the money supply and currency of their countries. This is why most investors consider the national governments of most modern industrial countries to be almost quot;
risk-freequot;
from a default point of view.Provincial or State GovernmentsProvincial or state governments also issue debt, depending on their constitutional ability to do this.Most investors consider provincial or state issuers to be very strong credits because they have the power to levy income and sales taxes to support their debt payments. Since they cannot control monetary policy like national governments, they are considered lesser credits than national governments.Municipal and Regional GovernmentsCities, towns, counties and regional municipalities issue bonds supported by their property taxes. School boards also issue bonds, supported by their ability to levy a portion of property taxes for education.Quasi-Government IssuersMany government related institutions issue bonds, some supported by the revenues of the specific institution and some guaranteed by a government sponsor. For example, The Federal Business Development Bank (FBDB) and the Canadian Mortgage and Housing Corporation (CMHC) bonds are directly guaranteed by the Federal government. Provincial crown corporations such as Ontario Hydro and Hydro Quebec are guaranteed by the Provinces of Ontario and Quebec respectively.CONVERTIBLE BONDSA convertible bond is a bond that gives the holder the right to quot;
convertquot;
or exchange the par amount of the bond for common shares of the issuer at some fixed ratio during a particular period. As bonds, they have some characteristics of fixed income securities. Their conversion feature also gives them features of equity securities.Convertible bonds are bonds. They have a coupon payment and are legally debt securities, which rank prior to all equity securities in a default situation. Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer.The exchange feature of a convertible bond gives the right for the holder to convert the par amount of the bond for common shares a specified price or quot;
conversion ratioquot;
. For example, a conversion ratio might give the holder the right to convert $100 par amount of the convertible bonds of Ensolvint Corporation into its common shares at $25 per share. This conversion ratio would be said to be quot;
4:1quot;
or quot;
four to onequot;
.The share price affects the value of a convertible substantially. Taking our example, if the shares of the Ensolvint were trading at $10, and the convertible was at a market price of $100, there would be no economic reason for an investor to convert the convertible bonds. Think of the opposite. When the share price attached to the bond is sufficiently high or quot;
in the moneyquot;
, the convertible begins to trade more like an equity. HIGH YIELD OR quot;
JUNKquot;
BONDSA high yield, or quot;
junkquot;
, bond is a bond issued by a company that is considered to be a higher credit risk. The credit rating of a high yield bond is considered quot;
speculativequot;
grade or below quot;
investment gradequot;
. This means that the chance of default with high yield bonds is higher than for other bonds. Their higher credit risk means that quot;
junkquot;
bond yields are higher than bonds of better credit quality. Studies have demonstrated that portfolios of high yield bonds have higher returns than other bond portfolios, suggesting that the higher yields more than compensate for their additional default risk.High yield or quot;
junkquot;
bonds get their name from their characteristics. As credit ratings were developed for bonds, the credit rating agencies created a grading system to reflect the relative credit quality of bond issuers. The highest quality bonds are quot;
AAAquot;
and the credit scale descends to quot;
Cquot;
, and finally to the quot;
Dquot;
or default category. Bonds considered to have an acceptable risk of default are quot;
and encompass quot;
BBBquot;
bonds and higher. Bonds quot;
BBquot;
and lower are called quot;
speculative gradequot;
and have a higher risk of default.Rule makers soon began to use this demarcation to establish investment policies for financial institutions, and government regulation has adopted these standards. Since most investors were restricted to investment grade bonds, speculative grade bonds soon developed negative connotations and were not widely held in investment portfolios. Mainstream investors and investment dealers did not deal in these bonds. They soon became known as quot;
junkquot;
since few people would accept the risk of owning them.High yield bond investment relies on credit analysis. Credit analysis is very similar to equity analysis in that it concentrates on issuer fundamentals, and a quot;
bottom-upquot;
process. It is concentrated on the quot;
downsidequot;
risk of default and the individual characteristics of issuers. Portfolios of high yield bonds are diversified by industry group, and issue type. Due to the high minimum size of bond trades and the specialist credit knowledge required, most individual investors are best advised to invest through high yield mutual funds.CORPORATE BONDSThe creditworthiness of corporate bonds are tied to the business prospects and financial capacity of the issuer.The business prospects of companies are dependent on the economy and the competitive situation of industries. Issuers are grouped by industry, for example real estate, resource and retail bonds. Industries with stable revenues and earnings are called quot;
non-cyclicalsquot;
, where as those whose revenues and earnings rise and fall with the economy and commodity prices are called quot;
cyclicalsquot;
.Issuers are also grouped by their credit ratings. Companies that have financial risk because of high levels of debt and variable revenues and earnings are called quot;
below investment gradequot;
or quot;
junkquot;
bonds because of their speculative nature. Higher quality bonds are considered quot;
.INFLATION-LINKED BONDSAn inflation-linked bond is a bond that provides protection against inflation. Most inflation-linked bonds, the Canadian quot;
Real Return Bond quot;
(RRB), the British quot;
Inflation-linked Giltquot;
and the new U.S. Treasury quot;
inflation-protected securityquot;
(IPS) are principal indexed. This means their principal is increased by the change in inflation over a period. As the principal amount increases with inflation, the interest rate is applied to this increased amount. This causes the interest payment to increase over time. At maturity, the principal is repaid at the inflated amount. In this fashion, an investor has complete inflation protection, as long as the investor's inflation rate equals the CPI.We must compare an inflation-linked bond to a conventional or quot;
nominalquot;
bond to understand it properly. A normal bond pays its coupon on a fixed principal amount. Using the Government of Canada 8% bond maturing in 2023 as an example, we are due 8%, or $8 on every $100 of principal, each year until we are finally repaid our principal of $100 at maturity. Contrast this with the Canadian RRB, the 4.25% maturing in 2021. It pays a 4.25% quot;
realquot;
interest rate or $4.25 on its principal each year. But the principal increases with inflation, which is based on the Canadian CPI. For example, the CPI, was 1.8% in 1995, the principal amount was increased by 1.8%. Since its issue in November 1991, the RRB has seen its principal amount increase by 8% to $108. At maturity, when the principal will be repaid by the Canadian government, the principal amount will have increased to well over $200.EUROBOND A bond issued in a currency other than the currency of the country or market in which it is issued. Usually, a Eurobond is issued by an international syndicate and categorized according to the currency in which it is denominated. A eurodollar bond that is denominated in U.S. dollars and issued in Japan by an Australian company would be an example of a Eurobond. The Australian company in this example could issue the Eurodollar bond in any country other than the U.S.Eurobonds are attractive financing tools as they give issuers the flexibility to choose the country in which to offer their bond according to the country's regulatory constraints. They may also denominate their Eurobond in their preferred currency. Eurobonds are attractive to investors as they have small par values and high liquidity. EXTENDIBLE & RETRACTABLE BONDSExtendible and retractable bonds have more than one maturity date. An extendible bond gives its holder the right to extend the initial maturity to a longer maturity date. A retractable bond gives its holder the right to advance the return of principal to an earlier date than the original maturity. Investors use extendible/retractable bonds to modify the term of their portfolio to take advantage of movements in interest rates. The characteristics of these bonds are a combination of their underlying terms. When interest rates are rising, extendible/retractable bonds act like bonds with their shorter terms When interest rates fall, they act like bonds with their longer terms.Extendible/retractable bonds are created by issuers because they pay a lower interest rate on these bonds than would otherwise be case or they quot;
sweetenquot;
the issue with this feature, making the issue easier to sell. Buyers are attracted to these bonds because the extension or retraction option is attractive to them.Extendible BondsAn extendible bond gives its holder the right to quot;
extendquot;
its initial maturity at a specific date or dates. The investor initially purchases a shorter term bond combined with the right to extend its term to a longer maturity date. An investor purchases an extendible bond to have the ability to take advantage of potentially falling interest rates without assuming the risk of a long term bond. As interest rates fall, the price of a shorter term bond rises less than the price of a longer term bond. This means the extendible bond begins to behave or quot;
tradequot;
as a longer term bond. On the other hand, if interest rates rose, the extendible bond would behave as a shorter term bond.Retractable BondsWith a retractable bond, an investor owns a longer term bond with the right to quot;
retractquot;
it at a specific date. Consider an investor that believes that interest rates will rise and bond prices will fall, but is not willing or able to sell out of bonds completely. This investor can buy a longer term retractable bond which behaves initially as a similar term long term bond. As interest rates rise the bond falls in price. Once its price is low enough, it will begin to behave as a short term bond and its price fall will be much less than a normal long term bond. At worst, the investor can retract it at the retraction date and receive the par amount back to reinvest.ZERO COUPON OR quot;
STRIPquot;
BONDSZero coupon or strip bonds are fixed income securities that are created from the cash flows that make up a normal bond.The cash flows of a normal bond consist of the regular interest or quot;
couponquot;
payments, that take place over the term of the bond, and the principal repayment that occurs at maturity of the bond. For example, the cash flows of the Government of Canada 8% bond with a maturity date of June 1, 2023 are:$4 every December and June 1st up to and including June 1, 2023, representing 4% of the $100 par value; and$100 on June 1, 2023, representing the repayment of the principal or par amount of the bondTaken individually, each of these payments is an obligation of the issuer, in this case, the Government of Canada. The process of quot;
strippingquot;
a bond involves deppositing bonds with a trustee and having the trustee separate the bond into its individual payment components. This allows the components to be registered and traded as individual securities. The interest payments are known as quot;
couponsquot;
after their source of cash flow, and the final payment at maturity is known as the quot;
residualquot;
since it is what is left over after the coupons are stripped off. Both coupons and residuals are known as quot;
zero couponquot;
bonds or quot;
zerosquot;
.Conceptually, a zero coupon security is just like a Treasury Bill or quot;
T-Billquot;
. The investor pays something up front in exchange for a promise to receive $100 on the maturity date. Take our example of the coupons and residual generated by stripping the Canada 8% of 2023. If we start on December 1, 1996 the first two payments are identical to a 6 month and 1 year T-Bill. An investor would receive $100 on June 1st and December 1st for each $100 par amount she purchased of these terms of coupons.The longer coupons get a bit more complicated. Take the coupon due on December 1, 2001, five years from December 1, 1996. What do we pay for this $100? First of all, we need to consider what interest rate would be appropriate. Reflecting on the term structure of interest rates, we know that we should use the yield on a similar term Government of Canada bond. Being bond market fans, we just happen to know that there is a Government of Canada issue the 9.75% of December 1, 2001. We also know that it currently yields 5.6% semiannually.FOREIGN CURRENCY BONDSA quot;
foreign currencyquot;
bond is a bond that is issued by an issuer in a currency other than its national currency. Issuers make bond issues in foreign currencies to make them more attractive to buyers and to take advantage of international interest rate differentials. Foreign currency bonds can quot;
swappedquot;
or converted in the swap market into the home currency of the issuer. Bonds issued by foreign issuers in the United States market in U.S. dollars are known as quot;
Yankeequot;
bonds. Bonds issued in British pounds in the British bond market are known as quot;
Bulldogsquot;
. Yen denominated bonds by foreign issuers are known as quot;
Samuraiquot;
bonds.The quot;
euromarketquot;
is another major source of foreign currency bond issues. European investors will buy the bonds of well known issuers like Ford, Toyota or General Electric or their international subsidiaries, in many different currencies depending on their currency views.Foreign currency bonds have a vocabulary all their own. Bonds issued in foreign currencies are given the names listed beside the currencies below:quot;
Yankee Bondsquot;
for U.S. dollarquot;
Samurai Bondsquot;
for Japanese Yenquot;
Bulldog Bondsquot;
for British pounds; andquot;
Kiwi Bondsquot;
for New Zealand dollarsForeign currency bonds have a much different risk and return profile than domestic bonds. Not only is their price affected by movements in a foreign country's interest rate, they also change in value depending on the foreign exchange rates. In Canada, for example, the Canadian dollar has moved upwards to 4% in U.S. dollar terms in very short periods of time. This exchange rate movement would result in price changes of 4% in Canadian dollars which completely overwhelms the coupon income of a bond. Studies have shown that the longer term risk and return characteristics of foreign bonds in domestic currencies are closer to domestic equity returns than domestic fixed income returns.EVALUATING A BOND FUND Every fund's prospectus outlines important information that can help you find the fund that may be right for you. The characteristics explained below are important factors that can help you evaluate your bond fund investment. Prospectuses for both Fidelity funds and FundsNetwork funds can be found in Products > Mutual Funds. Or use the Fund Evaluator to find a fund that meets the criteria.Investment GoalsBond funds have specific investment goals, such as pursuing high income or preservation of capital. Bond funds may follow different investment guidelines in order to pursue those goals. For example, some funds may limit their investments to U.S. government and government agency investments while other funds may invest in different bond sectors including corporate, government, government agency, and mortgage-backed bonds. The prospectus will state the fund's goals and investment guidelines.Average MaturityA bond fund maintains a dollar-weighted average maturity, which is the average of all the current maturities of the individual bonds in the fund. The longer the average maturity, the more sensitive the fund will be to changes in interest rates. Funds with quot;
short-term,quot;
quot;
intermediate-term,quot;
or quot;
long-termquot;
in their names indicate the average maturity the fund targets.DurationDuration estimates how much a bond's price fluctuates with changes in comparable interest rates. If rates rise 1.00%, for example, a fund with a 5-year duration is likely to lose about 5.00% of its value. Other factors also can influence a bond fund's performance and share price. A bond fund's actual performance may differ.Credit QualityThe average credit quality of a bond fund will depend on the credit quality of the underlying securities in the portfolio. Bond credit ratings can range from speculative to very high credit quality. Bonds rated medium to high credit quality are commonly referred to as quot;
investment grade-quality.quot;
Bonds rated below investment grade-quality are commonly called quot;
high yieldquot;
bonds or quot;
junkquot;
bonds. Funds that invest in lower-quality securities have the potential for higher yields and returns, but will also likely experience greater share price volatility.The credit quality of a bond is reflected in ratings assigned by independent rating companies such as Standard & Poor's and Moody's. These rating companies use a letter scale to indicate credit quality, with the highest credit quality being AAA. Bonds in default are assigned C and D ratings. This rating system can give investors important information on the creditworthiness of a bond.PerformanceIt's important to look at a fund's total return over time. Total return takes into account the value (or price) of the underlying bonds held by the fund in addition to income distributions from those bonds. Investors interested in income may want to look at the fund's 30-day yield. However, keep in mind that yield by itself does not tell the entire story. Higher yields usually come with strings attached. For example, the fund may achieve higher yields through investments in lower-quality securities, which may make the share price (or value) of your bond fund investment more volatile.Expenses and FeesAll mutual funds have operating expenses that include the costs of managing a fund. Some bond funds have sales charges, or loads, that are deducted from the amount of your initial investment. Some funds may charge a redemption fee for shares sold within a certain time period. Others may charge a small annual account fee. Make sure you are aware of all expenses before you invest.Fund ManagementBond markets today are more complex than they were just a few years ago. In selecting a mutual fund company for your bond fund investments, make sure the company is committed to providing the research and analysis that bond fund management now requires. BASICS FOR TRADING BONDS · Auction Market-Bid/Ask/Spread - Bonds like stocks trade on an auction market thus, they have a bid, the highest price offered to buy a bond, and an ask, the lowest price a seller hopes to get for their bonds. Most trades take place somewhere between these two prices. · Quantity - The prices quoted are usually for trades of $20,000 (20 Bonds) or higher. When buying bonds in smaller quantities an investor will commonly have to pay a higher price than the ask price. The reverse is true when selling a bond in the secondary market; the price you receive may be lower. · Identifying a Bond - When requesting a quote or placing an order for a bond be sure to carefully identify the bond completely by using: issuer, coupon rate, maturity date and, as an added precaution, the CUSIP number. Also include the number of bonds you want to buy or sell. Remember, 10 bonds represents $10,000 face value of securities. · Exchange Traded Bonds - Exchange traded bonds are much easier to buy and sell than OTC or unlisted issues. Most full service and discount brokerage firms will be able to place an exchange order. Make sure you tell the broker that it is an exchange- traded bond, they often won't know this. B e f o re you place an order ask for a quote. Identify the bond by: issuer, coupon rate, maturity date and as an added precaution the CUSIP number. Include the number of bonds you want to buy or sell. Agreeing to the ask price quoted should ensure your buy, however, you can also place a bid at a lower price. When selling a bond you can offer it at the bid price or enter a new ask price. When submitting new bids be reasonable and make it near the market price. Have patience, the more liquid a bond is the better chance for an early execution. Many investors place Good Till Cancelled order for bonds, but don't forget that you have placed the order. · Not Listed (OTC) Bonds - OTC bonds are difficult to buy and sell in small quantity. Most discount brokers will not shop for a specific bond. Thus, if it is not in their inventory, chances are an investor will not be able to execute an order. The sell side is also difficult for small quantities. Full service firms look beyond their own inventory however this does not guarantee an execution. Price quotes are very important and if it is possible multiple quotes should be obtained before placing and order. Be careful, don't chase a bond and watch for big spreads. It is best to specify a bid when buying and an offering or ask price when selling. · Accrued Interest - The amount of interest accumulated but not paid between the most recent payment and the sale of a bond. When purchasing bonds on the secondary market, this is the interest the former owner earned but has not been paid. It will be added to the buy price of a bond and be paid to the seller. The new buyer will receive the full semiannual interest payment on the next pay date. Bonds' Risks and Potential Return As with any investment vehicle, the higher the potential for return, the higher the risk. Bond yields reflect the issuer's credit quality as well as the fund's maturity. Lower-quality investments generally offer higher yields than higher-quality issues but may be more volatile. The higher yield compensates the investor for lending money to a company or municipality that is considered more likely to default – that is, not make timely interest or principal payments. This is called credit risk. The possibility that interest rates will rise after you purchase a fixed-income security is called interest rate risk, which is another risk factor and is explained in detail below. Interest Rates Affect Bonds When interest rates rise, the value of existing bonds and bond fund shares generally will decline. Conversely, when interest rates fall, the value of bond and bond fund shares generally will rise. Since it is difficult to predict whether interest rates will go up or down, T. Rowe Price believes you should create a broadly diversified bond portfolio that is appropriate for your investment goals. We do not recommend changing your bond portfolio mix in anticipation of rising or falling rates. However, investing in several bond funds with different investment strategies can help cushion the effects of interest rate risk and credit risk on your overall portfolio. For example, investing in both shorter and longer maturities can help your strategy stay on track during both high and low interest rate climates. Income Earned by Bond Funds To understand how bond funds earn money amid changing market conditions, we've illustrated some key principles below. A bond's coupon rate is the bond's fixed rate of interest expressed as a percentage of its face value (also known as par value) which is normally $1,000. Longer-term and lower-quality bonds generally have higher coupon rates than shorter-term and higher-quality issues. Among taxable investments, U.S. Treasury securities carry the lowest coupon rates because the federal government is the nation's most creditworthy borrower. Since most bonds pay interest semiannually, a bond with a face value of $1,000 and an 8% coupon rate pays $40 twice a year, for a total of $80 per year. While the coupon rate of a bond is fixed, its current yield can fluctuate with rising and falling interest rates that are dictated by market conditions. This is how interest rate risk can affect a bond’s total return. You can figure out the current yield by dividing the interest paid each year by the current price of the bond. A bond paying $80 interest per year yields 8% at par value. But if interest rates rise in the market, causing the bond’s price to fall to $900, the current yield rises to 8.9% ($80/$900 = 8.9%). If the value of the bond rises to a premium over par, say to $1,100, the current yield drops to 7.3% ($80/$1,100 = 7.3%). If you hold a bond until it matures, the bond’s compound annual rate of return is made up of two components: interest income and capital gain or loss. An 8% bond bought at a price of $900 and held until it matures in 10 years generates income of $800 and a capital gain of $100. Your average annual return, assuming all interest payments are reinvested at the same rate, is called the yield to maturity. Credit Ratings Rating services (such as Moody's or Standard & Poor's) evaluate how likely a bond issuer is to repay the debt and interest on time. A bond rated AAA/Aaa is the most creditworthy, while a bond rated BB/Ba or below is much riskier. An established, reputable company might have bonds carrying an investment-grade rating such as AA (with a low yield but a lower risk of default), while bonds issued by a company with a high debt level or other financial vulnerability might have a low rating. These lower-grade, high-yield bonds have a higher return potential but also a higher risk of default. Bond Rating CodesRATINGSTANDARD & POOR’SMOODY’SHighest qualityAAAAaaHigh qualityAAAaUpper-medium qualityAAMedium gradeBBBBaaSomewhat speculativeBBBaLow grade speculativeBBLow grade (default possible)CCCCaaLow grade (partial recovery possible)CCCaDefault (recovery unlikely)CC Portfolio Management Meaning of Portfolio Management The art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against. performance.Portfolio management is all about strengths, weaknesses, opportunities and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other tradeoffs encountered in the attempt to maximize return at a given appetite for risk. ,[object Object],In the case of mutual and exchange-traded funds (ETFs), there are two forms of portfolio management: passive and active. Passive management simply tracks a market index, commonly referred to as indexing or index investing. Active management involves a single manager, co-managers, or a team of managers who attempt to beat the market return by actively managing a fund's portfolio through investment decisions based on research and decisions on individual holdings. Closed-end funds are generally actively managed. BOND PORTFOLIO MANAGEMENT BANKS IN INDIA, generally invest in bonds issued by both the Central and State Government and their agencies. Investment in corporate debt is also increasingly becoming popular. Banks may invest in all types of bonds and of varying maturities and are expected to manage the interest rate risk arising from this investment by adopting suitable assets – liability management policies. Further, certain privately placed Non- SLR Bonds will be treated at par with Advances and be subjected to all prudential norms relating to advances. A typical bank’s investment portfolio would consist of all types of bonds and possibly equity shares also. Legal Framework Governing Securities Reserve Bank Of India is entrusted with the regulation of transactions in Government securities, money market Securities, gold related securities and repo in all instruments. In particular, aspects relating to Government Securities are covered under the Public debt Act and Rules and Notification under the Public debt Act, issued by both Central and State Governments. As regardes Corporate bonds, provision contained in Securities contracts (Regulation) Act , Depositories Act , Stock Exchange Bye laws and the terms and conditions of issues of the individual bonds are relevant . Investment and trading activities of bank in bond should conform with the regulations issued by RBI on classification and valuation in addition to under legal provision mainly contain in Securities Contracts (Regulation) Act. The RBI Regulationare mainly prudential. Accordingly banks are required to categories the investment in to three, viz,”Held To Maturity” (HTM), “Held for Trading”(HFT) and “Available For Sale”(AFS). HTM not to exceed 25% of the investments. HFT should be subjectt to the discipline and controls required for trading. AFS ciontains investments which are in neither HTM nor HFT categories. Categorisation is based on the jintensinon if the bank at the time of purchase of the security and shifting between categories is permissible only exceptionally. There are striggent rules for shifting between categories. Banks are not excepted to take any unrrealised gain to income account, but provide for all losses on a mark-to-market basis. While HTM investments need not be marked to market, HFT and AFS should be marked to market. RBI also has stipulated that banks should maintain an “Investment Fluctuation Reseerve” and build up adequate reserves out of realised gains every year. While the above are some of the salient features of the RBI instructions, Investments jmangagers in banks hsould be fully conversant with the instructions issued by RBI from time to time regarding the procedural and regulatory aspects relating to investments. In addition, it is necessary to take into consideration the management perspectives on returns and risk management. The organisational structure for treasury management also has an important bearing on the conduct of bond portfolio management on safe and sound lines. Banking Book and Trading Book The Investment policy is the document approved by the top management of a bank articulating the investment objectives, risk management aspects etc. Banks can adopt both passive or active approaches to management of their portfolios and the bank’s investment policy should specify the bank’s approach. The passive approach is usually identified with buy-and-hold strategy. Active bond portfolio management involves switching and swapping bonds as circumstances change in the market. Investments are categorised on the basis of the bank’s intent at the time of acquistion of securities. i.e. whether it is meant to be held till maturity (Held To Maturity) or sold. A further differentiation is possible is respect of the securities acquired for safe: whehter they are intended to be available for sale at an appropriate time depending on the bank’s liquidity needs (Available for Sale) or whether they are intended for operations (purchase and sale of securities with a view to take advantage of the expected movement in their market prices). Those securities purchased with the intension of trading have tdo be classified as “Held for Trading” and are subject to regulatory prescriptions regarding holding period, stop-loss etc. The aggregation of such securities held for trading forms the “Trading Book” of the bank. A bank which decides to maintain a trading book is expected to have in place proper risk management, trading policies, delegation of powers, skills, dealing infrastructure etc. Basel Committee’s capital adequacy norms prescribe maintenance of capital to cover market risk in the Trading Book. Securities, other than those in the trading book, are classified as belonging to the “Banking Book”. In the case of “Banking Book” the securities are treated on par with the other assets as far as balance sheet risks are concerned. Bond Portfolio Management Strategies Stock market investors will choose a particular risk level on the SML and invest at this point, choosing only those securities that lie on the SML (or above it). Stock investors have different levels of risk/return requirements Bond investors will do the same thing. A young, aggressive bond investor may choose a high risk bond & is willing to risk his principal investment. A retiree may not be willing to take a risky bond investment and may, instead invest in conservative bonds. Individual investors choose to invest in bonds. Also, pension plans, banks, insurance companies and other institutions invest in bonds. At any rate, all investors are interested in a bond investment strategy. There are three major types of strategies: passive portfolio management strategies active portfolio management strategies matched-funding strategies In the 1950s the bond market was considered a safe, conservative investment. At that time a buy-and-hold strategy was sufficient. However, times changed, in the 1960s inflation increased, and interest rates became more volatile. Thus, with more volatile interest rates, there was a great amount of profit potential with bonds. Also, in the 1970s the Macauley duration measure was re-discovered. Not all investors viewed the rise in interest rate volatility as a good thing. The pension fund and insurance companies that invest in bond found their job much more difficult. Thus, strategies based on duration were developed to aid pension fund managers to match their liabilities with properly constructed bond portfolios. Passive Bond Portfolio Strategies There are two major passive strategies: buy-and-hold indexing Buy-and-hold Strategy This strategy simply involves buying a bond and holding it until maturity. Bond investors would examine such factors as quality ratings, coupon levels, terms to maturity, call features and sinking funds. These investors do not trade actively to earn returns, rather they look for bonds with maturities or durations that match their investment horizon. There is also a modified buy-and-hold strategy in which investors buy bonds with the intention of holding them until maturity, but they still actively look for opportunities to trade into more desirable positions. [However, if you modify this too much it turns into an active strategy.] While the buy-and-hold strategy is a passive strategy, it still involves a great deal of work. Agency issues typically provide high quality bonds at a higher return than Treasury securities, callability affects the attractiveness of an issue, etc. Plus, you may want to develop a portfolio in which coupon payments are structured (and principal repayments). Techniques, Vehicles and Costs: Only default-free or very high quality securities should be held. Also, those securities that are callable by firm (allows the issuer to buy back the bond at a particular price and time) or putable by holder (allows bondholder to sell the bond to issuer at a specified price and time) will introduce alterations in the firm's cash flows, and probably should not be included in the buy-and-hold strategy. Also, those investors seeking to lock in a rate of return may choose a zero-coupon bond--good strategy for college tuition or retirement. The buy-and-hold strategy minimizes transaction costs and, if implemented astutely, can be highly productive. For example, if interest rates are currently high and are expected to remain so for an extended period of time, the buy-and-hold strategy will do well. Indexing Indexing involves attempting to build a portfolio that will match the performance of a selected bond portfolio index, such as the Shearson Lehman Hutton Government/Corporate Bond Index, Merrill Lynch Index, etc. This portfolio manager is judged on his ability to track the index. Techniques, Vehicles and Costs: The fixed income market is broader (in terms of security types) than the equity market. Also, even though the Shearson Lehman Hutton Corporate Bond Index has over 4,000 securities, it only represents high quality corporate bond issues. Thus, a compromise must be made when selected among different indexes. Also, the strategy of buying every bond in a market index according to its weight in the index is not a practical one. However, a relevant subset is possible. We may choose to emulate a narrower bond index. Alternative Vehicles: We may choose to randomly select bonds from the universe of bonds, or, we may choose the stratified approach (segmenting the index into components from which individual securities are chosen). When choosing the indexing option, bond portfolio management cannot be considered entirely passive. Also, there will be transaction costs associated with (1) purchasing the issues used to construct the index; and (2) reinvesting cash payments from coupon and principal repayments; and (3) rebalancing of portfolio if the composition of your target index changes. Whereas full replication of the target index would work best, this is impractical. If you choose the stratified method, your performance will probably not mirror your target index. How many securities should you have in your portfolio if you use the random sampling approach? McEnally and Boardman (1979) have found that, once an index is selected, close replication is possible with perhaps 40 bonds (for the long term). Stratified Approach: Consists of analyzing the index to determine various stratification levels (what portion of securities that make up index are Treasury, Aaa Industrial, Baa Financial, of X years to maturity, of X% coupon rate, etc.). The next step is to select the securities for your portfolio. Typically, at selection and at the rebalancing period (usually once a month) one security is chosen from each category (there could be 40 categories). There's no requirement as to which security is selected from each class. Active Management Strategies These strategies require major adjustments to portfolios, trading to take advantage of interest rate fluctuations, etc. There are four major active bond portfolio management strategies: Interest rate anticipation Valuation analysis Credit analysis Yield spread analysis In each strategy, the manager hops to outperform the buy-and-hold policy by using acumen, skill, etc. Interest Rate Anticipation This is the riskiest strategy because the investor must act on uncertain forecasts of future interest rates. The strategy is designed to preserve capital (lose as little as possible) when interest rates rise (and bond prices drop) and to receive as much capital appreciation as possible when interest rates drop (and bond prices rise). These objectives can be obtained by altering the maturity or duration of their portfolios. Longer maturity, or longer duration, portfolios will benefit the most from an interest rate decrease and vice versa. Thus, if a manager expects an increase in interest rates, they would structure portfolio to have the lowest possible duration. The problem faced with this type of strategy is the risk of mis-estimating interest rate movements. It is difficult (EXTREMELY) to predict (with accuracy) interest rate movements. However, if this is your strategy, you should be concerned with: direction of the change in interest rates the magnitude of the change across maturities, and the timing of the change. How your bond will be affected by changes in interest rates can usually be directly related to the security's duration. Thus, if you expect IR to drop, you should shift to high duration securities. Also, the timing as to when you expect the interest rate shift is important. You don't want to shift too early, because you may compromise some return. Obviously, you don't want to wait too late. Scenario Analysis: Say, quot;
what ifquot;
interest rates rise/fall by this much over the next month/year/etc. Analyze the individual bonds within your portfolio under each scenario and see how the returns are affected under each scenario. [See p. 8-30] The scenario analysis leads us to further analysis. Relative Return Value Analysis: We can calculate the overall expected return for each bond in our scenario (expected return under each interest rate scenario weighted by the probability of that scenario occurring) and the current duration of each bond in our portfolio and graph the relationship. Those bonds falling above a regression line (showing the general relationship) would be doing ok! Strategic Frontier Analysis: We can graph the bonds in our portfolio with the best case scenario (an interest rate decrease) on the vertical axis and the worst case scenario on the horizontal axis, as shown below: Those securities which fall into Quadrant I represent aggressive securities--if the best case happens, they will do well; however if the worst case happens they will be the worst performers. Those securities falling into Quadrant II are superior securities--they will perform well regardless of which scenario occurs. Quadrant III represents defensive securities--they will do well under the worst case scenario, but perform poorly if the best case occurs. Quadrant IV securities are inferior as they will perform poorly regardless of the scenario. You should sell securities falling into Quadrant IV. Normally a few securities would fall into Quadrants II and IV, with most falling into Quadrants I and III. Valuation Analysis The portfolio manager looks for undervalued bonds--those bonds that have a computed value (according to the portfolio manager) higher than the current market price). This also translates to those bonds whose expected YTM is lower than the current YTM. This strategy requires lots of analysis (continuous evaluations) and lots of trading based on the analysis. Based on your confidence in your analysis, you would buy undervalued bonds and sell overvalued bonds (or ignore them if they are not in your portfolio). Valuation Analysis: We can examine the term structure of pure discount bonds (zero coupon) and thus determine the value of US Treasuries, thus we can determine the default free characteristics of any other type of bond. Then we can attempt to determine the other factors that will affect bond yield by using multiple factor regression analysis (looking at things such as: quality rating, coupon effect, sector effect, call provision, sinking fund attributes, etc.) Using this factor analysis, we can determine the expected yield for the security (if the expected yield < current YTM then buy). However, there is some subjectivity in factor analysis. For instance, if there is some quot;
event riskquot;
(something affecting the financial stability of firm) missing from the analysis, or if there is any anticipation of a market upgrade... Credit Analysis Credit analysis involves examining bond issuers to determine if any changes in the firm's default risk can be identified. We try to determine if the bond rating agencies are going to change the firm's rating. Rating changes are prompted by internal changes within the firm as well as external changes. Various factors examined include financial ratios, GNP, inflation, etc. Many more downgradings occur during economic contractions [However from 1985-1990 downgradings increased substantially despite an economic expansion.]. To be successful in utilizing bond rating changes, you must accurately predict when the bond rating change will occur and take action prior to the change. The market does react to unexpected bond rating changes, however, it reacts quickly. Credit Analysis of High-Yield Junk Bonds. Junk bonds have a wide spread over bonds rated BBB and higher. Also, these yield spreads widen over time (during poor economic times the spread widens). Altman and Nammacher point out that the net return of junk bonds (average gross return minus losses from bonds that defaulted) has been superior to higher-rated debt [Of course, they're of higher risk.] Other points to note: Even though the rating categories have not changed, the quality of bonds today that fall into, let's say, the A category, has lessened over time. quot;
Specifically, the average values of the financial ratios that determine whether bonds are included in the B or CCC rating classes have declined over time.quot;
 Thus, bond portfolio managers will have to involved themselves in detailed credit analysis to determine those bonds that will not default. Credit Analysis: The assessment of default risk. Default risk has both systematic and unsystematic elements. First, individual bond issuers may experience difficulty in meeting their debt obligations. This could be an isolated incident, and can be diversified away (or eliminated by effective credit analysis). However, if default risk is precipitated by adverse general business conditions, then this would require more macro-oriented analysis. Many fixed-income investors complement the bond ratings providing by bond agencies (Fitch's, Moody's, Duff & Phelps, S&P's) with their own credit analysis, citing reasons such as: more accurate, comprehensive, and timely analyses and recommendations. Yield Spread Analysis A portfolio manager would monitor the yield relationships between various types of bonds and look for abnormalities. If a spread were thought to be abnormally high, you would trade to take advantage of a return to a normal spread. Thus, you need to know what the quot;
normalquot;
spread is, and you need the liquidity to make trades quickly to take advantage of temporary spread abnormalities. Spread Analysis: Involves anticipating changes in sectoral relationships. For example, prices and yields on lower investment grade bonds tend to move together (identifiable classes of securities are referred to as sectors). Changes in relative yields (or the spread) may occur due to: altered perceptions of the creditworthiness of a sector of the market's sensitivity to default risk changes in the market's valuation of some attribute or characteristic of the securities in the sector (such as a zero coupon feature); or changes in supply/demand conditions. The objective is to invest in the sector or sectors that will display the strongest relative price movements. Brokerage firms maintain historical records of yield spreads and are able to conduct specialized analyses for clients, such as measurement of the historical average, maximum, and minimum spread among sectors. Potential drawbacks of this method include the need to make numerous trades, the possibility of poor timing (how long will it take for the market to realize the abnormal spread), and the danger that overall changes in interest rates will dwarf these efforts. Differences The main difference between passive and active management is the assumption that the portfolio manager, whether it be a large institution or an individual, has the ability to either predict the direction of interest rates or exploit mispriced securities. While the manager does not have to be correct 100% of the time, he/she must be successful enough to provide returns in excess of a passively managed portfolio, minus transaction costs, taxes and management fees. Matched-Funding Techniques The matched-funding technique incorporates the passive buy-and-hold strategy and active management strategies. The manager tries to match specific liability obligations due at specific times to a portfolio of bonds in a way that minimizes the portfolio's exposure to interest rate risk (the uncertainty of returns due to possible changes in interest rates over time). These techniques are meant to avoid or offset risk, and they typically require constant monitoring and many transactions to achieve the intended goal. Many of these techniques were developed in the 1980s (due to highly volatile interest rates) for pension funds (known obligations), individual retirement planning, college education, etc. These investors needed $x at x date. With interest rates that were highly volatile, at the needed date, bond prices could be down (substantially below the needed amount). Thus, many investors wanted techniques that would help them match future liability streams with bond portfolios that would provide the required funds without having to worry about where interest rates would be at the time. Dedicated Portfolios Pure Cash-matched dedicated portfolio: most conservative method. Construct a bond portfolio with a stream of payments, sinking funds, and maturing principal payments to exactly match specific liability schedule. This requires estimating your future obligations (pension fund payouts, college tuition, etc.) You could choose zero-coupon bonds that had maturity dates exactly when you needed the funds. This is an entirely passive portfolio that requires no reinvestment (zero coupon bonds pay no cash coupon payment and matures the day you need the funds, so as soon as you receive your maturity payment, you would payout your pension money). Technically it is difficult to determine exactly WHEN your cash flow payouts will be due, so it is best to apply a somewhat conservative approach. Dedicated Cash-matched portfolio with reinvestment: Assumes that cash flows don't always come when needed (may come earlier) and will be reinvested. Therefore, will require smaller sums of initial funds to meet future goals. Portfolio Immunization Attempts to enable one to quot;
lock-inquot;
going interest rates and not have to worry about interest rate shifts. Developed by Fisher and Weil in 1971. Components of Interest Rate Risk: One of the major problems faced by bond portfolio managers is having the needed amount of funds at a specific date (the ending wealth requirement) -- your investment horizon. If interest rates never changed during your investment horizon, you could reinvest your coupon payments at the stable interest rate and earn the promised YTM. However, in reality, the yield curve is not flat and interest rates do change. Consequently, investors face interest rate risk. There are two components of interest rate risk: Price risk: if interest rates change before the end of your investment horizon and the bond is sold prior to maturity (you would quot;
winquot;
with an interest rate decrease and quot;
losequot;
with an interest rate increase. Coupon reinvestment risk: The promised YTM assumes that all coupon payments are reinvested at the promised YTM. If interest rates change, this cannot be accomplished. You will quot;
winquot;
with an increase in IR and vice versa. Immunization and Interest Rate Risk: Note that the quot;
winquot;
situation under price risk is exactly opposite the quot;
winquot;
situation under coupon reinvestment risk. Bond portfolio managers would like to eliminate these two interest rate risks. Fisher and Weil (because of the opposing effects of IR on price and coupon reinvestment risk) developed a precise immunization process to eliminate IR risk. Fisher and Weil argue that a portfolio has been immunized if its value at the end of the period is the same (or higher) than what it would have been if interest rates had not changed during the investment horizon. They assume that IR changes will affect all rates by the same amount (i.e. all rates will rise by .005 or fall by .005--long term bonds won't rise by .007 and short term by .005, both will rise by .005). If this is the case, then portfolio immunization can be achieved by holding a portfolio of bonds with a modified duration equal to the remaining investment horizon. quot;
To obtain a given portfolio duration, you set the value-weighted average modified duration of the portfolio at the investment horizon and keep it equal to the remaining horizon value over time.quot;
 Example of Immunization. Compare the results of choosing a bond with a maturity equal to the investment horizon vs. a modified duration equal to the investment horizon. Assumptions: investment horizon is 8 years, current YTM is 8% on 8 year bonds. If there is no change in yields, the expected ending-wealth would be $1000 * 1.08^8 = $1,850.90. This should also be the expected ending-wealth for a fully immunized portfolio. There are two strategies for portfolio immunization: the maturity strategy (term to maturity equal to investment horizon); and the duration strategy (set modified duration equal to investment horizon). Results with Maturity StrategyResults with Duration Strategy YearCash FlowReinv.RateEndingValueCashFlowReinv.RateEndingValue180.088080.0880280.08166.4080.08166.40380.08259.7180.08259.71480.08360.4980.08360.49580.06462.1280.06462.12680.06596.8580.06596.85780.06684.0480.06684.0481080.061805.081120.64.061845.75 Under the maturity strategy simply choose a bond with 8 years to maturity. Under the duration strategy, find a bond with a modified duration that equal 8 (or as close to 8 as possible). Now we'll work through the example assuming that interest rates decrease from 8% to 6% in year 4 and again from 8% to 12% in year 4. From 8% to 6%: From 8% to 12% Results with Maturity StrategyResults with Duration StrategyYearCash FlowReinv.RateEndingValueCashFlowReinv.RateEndingValue180.088080.0880280.08166.4080.08166.40380.08259.7180.08259.71480.08360.4980.08360.49580.12483.7580.12483.75680.12621.8080.12621.80780.12776.4280.12776.4281080.121949.591012.4.121881.99 Notice that under the maturity strategy you would lose (from an expected value of $1,850.90 to an actual value of $1,805.08); whereas under the duration strategy you would still have an expected value of $1,850.90 and you would achieve $1,845.72 or $1,881.99 (depending on whether interest rates fell or rose). While we would have preferred the ending wealth achieved under the rise in IR scenario using the maturity strategy, due to the uncertainty of IR changes, it's impossible to know, before the fact, where interest rates will actually be. The duration strategy actually achieved the ending wealth closest to the expected wealth under both scenarios. Implementing Immunization. While on the surface the immunization strategy may seem simple, even passive, in reality it is not (except zero coupon bonds face no coupon reinvestment risk or price risk--as its duration is its term to maturity). Most portfolios (non-zero-coupon portfolios) require frequent rebalancing to maintain the modified duration/investment horizon matching. You cannot initially set them equal and then ignore them after that. Duration is positively affected by term to maturity, so, as time passes as your investment horizon shortens, so does the duration of the bond portfolio (assuming nothing else has changed). However, duration changes at a slower pace than term to maturity. Also, duration is affected by changes in interest rates, etc. So, it takes constant rebalancing to keep track of duration matching immunization strategy Bond management strategies are based on sector rotation and security selection. Sector Rotation in Bonds A sector rotation strategy for bonds involves varying the weights of different types of bonds held within a portfolio. An investment manager will form an opinion on the valuation of a specific sector of the bond market, based on the credit fundamental factors for that sector and relative valuations compared to historical norms and technical factors, such as supply and demand, within that sector. A manager will usually compare her portfolio to the weightings of the benchmark index that she is being compared to on a performance basis. Security Selection for Bonds Security selection for bonds involves fundamental and credit analysis and quantitative valuation techniques at the individual security level. Fundamental analysis of a bond considers the nature of the security and the potential cash flows attached to it. Credit analysis evaluates the likelihood that the payments will be received as contemplated, or at all. Modern quantitative techniques use statistical analysis and advanced mathematical techniques to attach values to the cash flows and assess the probabilities inherent in their nature. Modern Portfolio Theory According to Ben McClure if an investor were to craft the perfect investment, then he would probably want its attributes to include high returns coupled with little risk. The reality, of course, is that this kind of investment is next to impossible to find. Not surprisingly, people spend a lot of time developing methods and strategies that come close to the quot;
perfect investmentquot;
. But none is as popular, or as compelling, as modern portfolio theory (MPT). Here we look at the basic ideas behind MPT, the pros and cons of the theory, and how MPT affects the management of your portfolio. The Theory One of the most important and influential economic theories dealing with finance and investment, MPT was developed by Harry Markowitz and published under the title quot;
Portfolio Selectionquot;
in the 1952 Journal of Finance. MPT says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification - chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket.For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, it is the deviation from the average return. Each stock has its own standard deviation from the mean, which MPT calls quot;
riskquot;
.The risk in a portfolio of diverse individual stocks will be less than the risk inherent in holding any single one of the individual stocks (provided the risks of the various stocks are not directly related). Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that pays off when it doesn't rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio. In other words, Markowitz showed that investment is not just about picking stocks, but about choosing the right combination of stocks among which to distribute one's nest eggs. Two Kinds of Risk Modern portfolio theory states that the risk for individual stock returns has two components:Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.Unsystematic Risk - Also known as quot;
specific riskquot;
, this risk is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio (see Figure 1). It represents the component of a stock's return that is not correlated with general market moves. For a well-diversified portfolio, the risk - or average deviation from the mean - of each stock contributes little to portfolio risk. Instead, it is the difference - or covariance - between individual stocks' levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks. Figure 1 The Efficient Frontier Now that we understand the benefits of diversification, the question of how to identify the best level of diversification arises. For every level of return, there is one portfolio that offers the lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These combinations can be plotted on a graph, and the resulting line is the efficient frontier. Figure 2 shows the efficient frontier for just two stocks - a high risk/high return technology stock (Google) and a low risk/low return consumer products stock (Coca Cola). Figure 2 Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum expected return for a given level of risk. A rational investor will only ever hold a portfolio that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on determines the position of the portfolio on the line.Modern portfolio theory takes this idea even further. It suggests that combining a stock portfolio that sits on the efficient frontier with a risk-free asset, the purchase of which is funded by borrowing, can actually increase returns beyond the efficient frontier. In other words, if you were to borrow to acquire a risk-free stock, then the remaining stock portfolio could have a riskier profile and, therefore, a higher return than you might otherwise choose MPT Means for investor Modern portfolio theory has had a marked impact on how investors perceive risk, return and portfolio management. The theory demonstrates that portfolio diversification can reduce investment risk. In fact, modern money managers routinely follow its precepts That being said, MPT has some shortcomings in the real world. For starters, it often requires investors to rethink notions of risk. Sometimes it demands that the investor take on a perceived risky investment (futures, for example) in order to reduce overall risk. That can be a tough sell to an investor not familiar with the benefits of sophisticated portfolio management techniques. Furthermore, MPT assumes that it is possible to select stocks whose individual performance is independent of other investments in the portfolio. But market historians have shown that there are no such instruments; in times of market stress, seemingly independent investments do, in fact, act as though they are related.Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio returns, but finding a truly risk-free asset is another matter. Government-backed bonds are presumed to be risk free, but, in reality, they are not. Securities such as gilts and U.S. Treasury bonds are free of default risk, but expectations of higher inflation and interest rate changes can both affect their value.Then there is the question of the number of stocks required for diversification. How many is enough? Mutual funds can contain dozens and dozens of stocks. Investment guru William J. Bernstein says that even 100 stocks is not enough to diversify away unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book quot;
Modern Portfolio Theory And Investment Analysisquot;
(1981), conclude that you would come very close to achieving optimal diversity after adding the twentieth stock. Advanced portfolio managementReviewquot;
Effective in presenting the mechanics of bond portfolio management for those who understand basic bond math worth the price.quot;
––Financial Analysts Journal Product DescriptionIn order to effectively employ portfolio strategies that can control interest rate risk and/or enhance returns, you must understand the forces that drive bond markets, as well as the valuation and risk management practices of these complex securities. In Advanced Bond Portfolio Management, Frank Fabozzi, Lionel Martellini, and Philippe Priaulet have brought together more than thirty experienced bond market professionals to help you do just that. Divided into six comprehensive parts, Advanced Bond Portfolio Management will guide you through the state–of–the–art techniques used in the analysis of bonds and bond portfolio management. Topics covered include: General background information on fixed–income markets and bond portfolio strategies The design of a strategy benchmark Various aspects of fixed–income modeling that will provide key ingredients in the implementation of an efficient portfolio and risk management process Interest rate risk and credit risk management Risk factors involved in the management of an international bond portfolio Filled with in–depth insight and expert advice, Advanced Bond Portfolio Management is a valuable resource for anyone involved or interested in this important industry. Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies Browsing Options: In order to effectively employ portfolio strategies that can control interest rate risk and/or enhance returns, you must understand the forces that drive bond markets, as well as the valuation and risk management practices of these complex securities. In Advanced Bond Portfolio Management, Frank Fabozzi, Lionel Martellini, and Philippe Priaulet have brought together more than thirty experienced bond market professionals to help you do just that. Divided into six comprehensive parts, Advanced Bond Portfolio Management will guide you through the state-of-the-art techniques used in the analysis of bonds and bond portfolio management. Topics covered include: General background information on fixed-income markets and bond portfolio strategies The design of a strategy benchmark Various aspects of fixed-income modeling that will provide key ingredients in the implementation of an efficient portfolio and risk management process Interest rate risk and credit risk management Risk factors involved in the management of an international bond portfolio Filled with in-depth insight and expert advice, Advanced Bond Portfolio Management is a valuable resource for anyone involved or interested in this important industry. State Bank of India (SBI) The evolution of State Bank of India can be traced back to the first decade of the 19th century. It began with the establishment of the Bank of Calcutta in Calcutta, on 2 June 1806. The bank was redesigned as the Bank of Bengal, three years later, on 2 January 1809. It was the first ever joint-stock bank of the British India, established under the sponsorship of the Government of Bengal. Subsequently, the Bank of Bombay (established on 15 April 1840) and the Bank of Madras (established on 1 July 1843) followed the Bank of Bengal. These three banks dominated the modern banking scenario in India, until when they were amalgamated to form the Imperial Bank of India, on 27 January 1921. An important turning point in the history of State Bank of India is the launch of the first Five Year Plan of independent India, in 1951. The Plan aimed at serving the Indian economy in general and the rural sector of the country, in particular. Until the Plan, the commercial banks of the country, including the Imperial Bank of India, confined their services to the urban sector. Moreover, they were not equipped to respond to the growing needs of the economic revival taking shape in the rural areas of the country. Therefore, in order to serve the economy as a whole and rural sector in particular, the All India Rural Credit Survey Committee recommended the formation of a state-partnered and state-sponsored bank. The All India Rural Credit Survey Committee proposed the take over of the Imperial Bank of India, and integrating with it, the former state-owned or state-associate banks. Subsequently, an Act was passed in the Parliament of India in May 1955. As a result, the State Bank of India (SBI) was established on 1 July 1955. This resulted in making the State Bank of India more powerful, because as much as a quarter of the resources of the Indian banking system were controlled directly by the State. Later on, the State Bank of India (Subsidiary Banks) Act was passed in 1959. The Act enabled the State Bank of India to make the eight former State-associated banks as its subsidiaries. The State Bank of India emerged as a pacesetter, with its operations carried out by the 480 offices comprising branches, sub offices and three Local Head Offices, inherited from the Imperial Bank. Instead of serving as mere repositories of the community's savings and lending to creditworthy parties, the State Bank of India catered to the needs of the customers, by banking purposefully. The bank served the heterogeneous financial needs of the planned economic development. BranchesThe corporate center of SBI is located in Mumbai. In order to cater to different functions, there are several other establishments in and outside Mumbai, apart from the corporate center. The bank boasts of having as many as 14 local head offices and 57 Zonal Offices, located at major cities throughout India. It is recorded that SBI has about 10000 branches, well networked to cater to its customers throughout India ATM Service SBI provides easy access to money to its customers through more than 8500 ATMs in India. The Bank also facilitates the free transaction of money at the ATMs of State Bank Group, which includes the ATMs of State Bank of India as well as the Associate Banks – State Bank of Bikaner & Jaipur, State Bank of Hyderabad, State Bank of Indore, etc. You may also transact money through SBI Commercial and International Bank Ltd by using the State Bank ATM-cum-Debit (Cash Plus) card. SubsidiariesThe State Bank Group includes a network of eight banking subsidiaries and several non-banking subsidiaries. Through the establishments, it offers various services including merchant banking services, fund management, factoring services, primary dealership in government securities, credit cards and insurance. The eight banking subsidiaries are: State Bank of Bikaner and Jaipur (SBBJ) State Bank of Hyderabad (SBH) State Bank of India (SBI) State Bank of Indore (SBIR) State Bank of Mysore (SBM) State Bank of Patiala (SBP) State Bank of Saurashtra (SBS) State Bank of Travancore (SBT) Products And Services Personal Banking SBI Term Deposits SBI Loan For Pensioners SBI Recurring Deposits Loan Against Mortgage Of Property SBI Housing Loan Loan Against Shares & Debentures SBI Car Loan Rent Plus Scheme SBI Educational Loan Medi-Plus Scheme Other Services Agriculture/Rural Banking NRI Services ATM Services Demat Services Corporate Banking Internet Banking Mobile Banking International Banking Safe Deposit Locker RBIEFT E-Pay E-Rail SBI Vishwa Yatra Foreign Travel Card Broking Services Gift Cheque Bonds in SBI Softer yields to help bank write back provisions, boost Q2 bottom line. The country’s largest lender, State Bank of India , is expected to report a healthier bottom line in the second quarter, thanks to writeback of provisions on the bond portfolio. Based on the current bond prices, SBI is expected to write back Rs 700-800 crore of provisions. Yields on government bonds have softened in the second quarter. This is in contrast to the Rs 1,656 crore mark-to-market provisions the bank made during April-June this year as yields went up 73 basis points at the close of the quarter. The final write-back figure will depend on how bond prices move over the next fortnight. Analysts said that a dip in yields and the consequent write-back of provisions is one of the major factors that are helping public sector bank stocks rally despite the global financial crisis. SBI’s shares closed 2.14 per cent higher at Rs 1,561.35 on the Bombay Stock Exchange. The problem was accentuated for SBI as it had to provide nearly Rs 1,000 crore for erosion in the value of special bonds it received from the Centre as its share of subscription for a rights issue in March 2008. Compared to the yield of 8.66 per cent on June 30, 2008, the yield on 10-year paper was 8.31 per cent on Thursday. This will help banks report healthier numbers despite a slower growth in income. On March 31, the yield was 7.93 per cent. During the first quarter, SBI reported a 15 per cent rise in its net profit to Rs 1,640.79 crore. During the July-September 2008, the profit rose 86 per cent to Rs 2204.56 crore. SBI has the largest bonds portfolio and is estimated to be around Rs 1,80,000 crore at present. SBI executives have maintained that by raising lending rates twice in the second quarter, they have managed to protect the net interest margin, which was estimated at 3.03 per cent at the end of June 2008. The gain from this is, however, still unclear as borrowing costs have also gone up, especially on term deposits. With banks facing higher delinquency levels due to a rise in interest rates and a slowdown in economic activity, the provisions for sticky assets may go up, executives said. But they appeared confident that the write-back will make up for some of the additional provisioning. State Bank of India (SBI), the country’s largest bank, today launched its Rs 1,000 crore subordinated bond issue to shore up its tier-II capital. The issue has a tenure of 113 months and carries a coupon of 7.45 per cent, payable annually. Dealers said the tier-II issue will have an unspecified greenshoe option and will remain open till December 5. This issue is part of the bank’s plans to raise Rs 3,300 crore through tier-II bonds.Several other banks are also about to hit the capital market to raise tier-II capital. These include Uco Bank (Rs 400 crore), Andhra Bank (Rs 400 crore), Union Bank of India (Rs 800 crore), Bank of India (Rs 750 crore) and Bank of Baroda (Rs 1,500 crore). A few private banks have already raised subordinated debt needed to boost capital adequacy. ICICI Bank raised Rs 700 crore of tier-II capital, HDFC Bank Rs 1,000 crore and Yes Bank Rs 200 crore. Tier-I capital includes paid-up capital, statutory reserves and other disclosed reserves. tier-II capital consists of subordinate debt and revaluation reserves. Tier-II capital can be equal to tier-I capital, but subordinated debt can only be 50 per cent of tier-I capital. With the deadline for compliance to Basel-II nearing, banks are experiencing a rise in their requirements for regulatory capital. To maintain their capital adequacy ratios well above the regulatory 9 per cent, banks are taking the tier-II route. The current industry-wide capital adequacy ratio (CAR) stands at 12.0-12.5 per cent, which would drop to about 10 per cent, following the implementation of Basel-II. The Reserve Bank of India (RBI) recently allowed banks to include provisions under investment fluctuation reserve (IFR) as part of tier-I capital (IFR has been hitherto been classified as Tier II capital). This change permits considerable headroom for banks to increase their Tier-II capital. A study by leading credit rating agency, Crisil, reveals that Indian banks can potentially borrow an additional Rs 11,100 crore in subordinate bonds, as a result of the change in the treatment of IFR. Banks are required to create IFR out of their profits equivalent to 5 per cent of their investment portfolio under held for trading (HFT) and available for sale (AFS) categories. IFR is meant to cushion interest rate risk on these investments. Crisil’s analysis also reveals that, on an overall basis, the banks covered in its study can grow their risk-weighted assets by up to 32 per cent, and still, from a regulatory perspective, maintain a comfortable capital adequacy of 11 per cent. This will happen even without raising any fresh equity, by fully utilising the existing headroom for raising subordinate debt (this headroom is estimated to be Rs.14,800 crore for the banks covered under the CRISIL study) and by completely availing the additional subordinate debt window being provided by the RBI notification. SBI to raise $3.8 bln via bonds by March 2010 MUMBAI (Reuters) - State Bank of India, the country's largest lender, plans to raise 180 billion rupees ($3.8 billion) through bonds by March 2010, the bank said on Tuesday, a day ahead of its 20-billion-rupee bond issue. In a note to the stock exchange, SBI said it would offer bonds with a minimum maturity of more than 60 months, in tranches through structured deals, private placement or retail participation. On Monday, SBI set a coupon of 8.90 percent on a 15-year upper Tier-II subordinated debt issue, to be launched on Wednesday. Several Indian banks have stepped up bond sales over the past month to meet Basel II requirements, which by March 2009 aim to match capital reserve requirements to the risks faced by banks. quot;
Yields are very low and attractive now, but Basel II is also a reason why banks are issuing bonds,quot;
Harihar Krishnamoorthy, treasurer at Development Credit Bank, said. India's benchmark 10-year federal bond on Tuesday plunged below 6 percent for the first time since Sept. 2004. It has eased from a seven-year high of 9.55 percent touched in early July as falling inflation and slowing growth led the central bank to lower key interest rates. The Reserve Bank of India in October reversed a 4-½ year monetary tightening cycle to cut the repo rate, at which it lends money to banks. In a series of policy easings since then, it has cut the repo rate by 250 basis points to 6.5 percent now. In its latest move, the bank on Dec. 6 slashed both the repo and the reverse repo rate, at which it absorbs funds from banks, by 100 basis points each. ($1 = 47.8 rupees) Govt issues bonds to SBI for subscribing to rights issue New Delhi, Mar 27 (PTI) The government issued close to Rs 10,000 crore bonds to State Bank of India to buy around 60 per cent of its rights issue, which is priced at Rs 1,590 a share. The 16-year Special Bonds are precisely for Rs 9,996.012 crore and would carry a coupon rate of 8.35 per cent. quot;
The special bonds are being issued at par to SBI today as subscription towards Rights Issue of equity shares of SBI,quot;
an official release said. The investment in special bonds by banks and insurance companies will not be reckoned as an eligible investment in government securities SBI to raise Rs 16,736 cr from rights issue Mumbai, Jan 14 (PTI) -- Country's largest lender SBI today decided to raise Rs 16,736.31 crore from its much-awaited rights issue, which will be priced at Rs 1,590 a share. According to a decision of the Central Board of the bank here, existing shareholders would be given a share for every five shares. The price at which shares would be offered represents about 36 per cent of discount to State Bank of India's current share price. This means shareholders would get a share at a premium of Rs 1,580, if face value of Rs 10 is considered, but at a discount of Rs 889, if today's current price at Rs ... SBI Will Issue Bond To Expand Its Overseas Network Mumbai: State Bank of India (SBI) is set to raise upto USD one billion from the international market this month through the issue of five year maturity bonds. This will fill up the immediate fund-requirement of the banking behemoth to fuel its expansion plans in key-overseas markets, primarily setting up of around 40 newoffices and expanding the lending book. The bond issue, a part of SBI's USD five billion Medium Term Notes (MTN) programme launched in 2004, will target investors including banks, insurance companies, hedge funds and private equities in the global market, a seniorSBI official told PTI here. State Bank of India has designed the bond issue through Reg-S route, which means it can target only non-US clients through the bond issue to raise a maximum of USD one billion. The bank plans to launch international roadshows for the programme in the next few weeks and has appointed five leading investment banks -- Barclays, JP Morgan, Citi, HSBC and UBS as lead arrangers, the official said. However, the official declined to give details of interest rate at which SBI would issue bonds to global investors. quot;
We will be giving it (bonds) to the arrangers, who, in turn will distribute among their clients. The issue could be a mix of fixed and floating rate bonds. We are yet to arrive at the coupon rate,quot;
the official said. SBI has so far raised around USD 2.3 billion through the MTN programme. Assuming that the lender will successfully raise USD one billion from the current issue, it will still have a headroom to raise USD 1.7 billion when required through the MTN route, the official said. The banking giant plans to open over 40 new offices globally in the next one year. Presently the bank has 132 foreign offices including five subsidiaries. Overseas business currently contributes around 12 per cent of SBIs balancesheet. SBI's international subsidiaries are Indonesia (6 branches), Mauritius (12 branches), Nepal (32 branches), California (7 branches) and Canada (7 branches). Other destinations, where the bank plans to open newoffices include Middle East, Singapore, South Africa, Bangladesh, Saudi Arabia, USA, Srilanka, Nepal and HongKong. Credit Ratings To SBI Fitch Assigns 'BBB-' to State Bank of India's Senior Bonds Announcement / Banking October 21, 2009, 19:06 IST Fitch Ratings has today assigned a 'BBB-'rating to State Bank of India's senior unsecured USD bonds to be issued under the bank's USD5bn Medium-Term Note programme. The size and pricing of the issue is expected to be finalised today. The agency has simultaneously affirmed the outstanding ratings of State Bank of India (SBI) as follows: Long-term foreign currency Issuer Default rating (IDR) at 'BBB-'; Short-term foreign currency IDR at 'F3'; National Long-term rating at 'AAA(ind)'; Individual at 'C' ; Support at '2'; and Support Rating Floor at 'BBB-'. The Rating Outlook is Stable. The list of outstanding issues rated is attached below. SBI's Long-term ratings are driven by its quasi-sovereign risk status and huge systemic importance, as well as its competitive edge as India's largest domestic bank with an extensive branch reach, strong deposit franchise, above-average capital ratios and better income diversity compared to other government banks. The Long-term foreign currency IDR is at the Support Rating Floor level. Funding is mostly through domestic retail deposits sourced from its pan-Indian branch network (the largest amongst Indian banks), which supports the bank's liquidity. SBI also has a major share of the banking business of the central government and the various state governments, which helps boost its share of low cost current and savings deposits, versus other Indian banks. The bank's reported Tier 1 capital ratio has been above 8% since FY98; the ratio was at 9.7% at end-June 2009 and comprised mostly of core capital. Given the statutory minimum shareholding that the government needs to maintain in the bank, SBI would ultimately rely on the government for capital; the government subscribed to the bank's rights issue of common equity in March 2008. The rapid loan growth in recent years (loans doubled between FY06 and FY09), together with the economic slowdown leads to asset quality concerns, and the bank's NPL and stressed accounts could rise in FY10 and FY11. That said, the sector diversity of SBI's loan portfolio provides some respite against sudden spikes in the NPL ratios; Fitch notes that the bank's reported gross NPL ratio and restructured loan portfolio at end-June 2009 were both close to the average for Indian banks. Fitch's stress test on Indian banks (for more information please refer to the Special Report titled quot;
Stress Test on Indian Banks: Higher-Rated Banks Mostly Able to Preserve Equityquot;
dated 1 October 2009) suggests that SBI's credit costs in the stress scenario can be absorbed by its pre-impairment operating profit, leaving the capital unimpaired under fairly harsh stress assumptions. That said, the bank's performance in FY10 could come under pressure on several fronts. SBI's focus since FY09 on regaining market share in its lending business has affected its net interest margin (NIM), and while NIM can be expected to recover as deposits are re-priced at rates lower than 2008, it may remain lower than the targeted 3% (Q1FY10: 2.3%). Credit costs would likely rise during the current downturn in asset quality; in addition, the bank also plans to raise its currently low specific loan loss reserves level (FY09: 38%) closer to the system average of 50% of gross NPL. Profits could also be impacted if interest rates result in mark-to-market losses on its available-for-sale portfolio of government securities, which needs to be adjusted through profits under local accounting. The healthy accretion of fee income from both the banking business provides comfort and helped maintain ROA close to 1% during Q1FY10. With over 11,000 branches and 8,500 ATMs, SBI continues to dominate the banking sector in India. Issue Ratings of SBI: EUR100m senior bonds: 'BBB-'; USD500m senior bonds: 'BBB-'; USD300m senior bonds: 'BBB-'; and USD400m perpetual non-cumulative Tier 1 bonds rated: 'BB'; Fitch Ratings currently maintains coverage of approximately 6,000 financial institutions, including over 3,200 banks and 2,200 insurance companies. Finance & leasing companies, broker-dealers, asset managers, managed funds, and covered bonds make up the remainder of Fitch Ratings’ financial institution coverage universe. Fitch India has Five rating offices located at Mumbai, Delhi, Chennai, Kolkata and Bangalore. Fitch is recognised by Reserve Bank of India, Securities Exchange Board of India (SEBI) and National Housing Bank. Crisil reaffirms rating for SBI bonds The 'AAA' (triple A) rating assigned to the Rs. 1,000 crore bond programme of State Bank of India has been reaffirmed by the Credit Rating Information Services of India (Crisil). The P1 plus (P one plus) rating assigned to the certificates of deposit programme of Bank of India has also been reaffirmed. The rating reaffirmation reflects the large size and sound capitalisation of the bank, and its importance to the Indian economy. The rating also takes into account the strong resources position of SBI arising out of its reach, its dominant market position and the diversity of its earning streams. The key sensitivities in the rating of State Bank of India in future would be the asset quality, ability to maintain market share in deposits at competitive costs and ability to manage interest rate risk on its investment portfolio. The bank is the largest institution in the Indian financial sector with assets of more than Rs. 222,500 crores and deposits of more than Rs. 169,000 crores as at March 31, 1999, having a market share of over 21 per cent in deposits and around 20 per cent in advances among all scheduled commercial banks. Conclusion Since bond and fixed-income portfolios are held by most institutional investors in addition to stock portfolios, their relative importance in terms of total portfolio returns necessitate a closer analyses of bond valuation and bond volatility. The underlying determinants of bond value are the nominal interest rates (i.e., real interest rate plus inflation premium) and their term premia. Term premium results from the hypotheses that investors have different time preferences when trading bonds with different maturities in different markets. Both nominal interest rate and term premium combine to form the bond yield thereby determining the market value of bond. The yield curve - a relationship between the bond yield and its maturity - represents the term structure of the interest rate. A positively sloping yield curve implies that the future interest rates will be higher, and vice versa. This term structure helps the bond investors to form their expectations correctly in order to maximize their bond portfolio returns. The change in yield curve affects the bond price through duration (interest rate risk) and convexity. Duration gives the bond investors how sensitive the bond prices are to the changes in bond yields or the interest rates. As yield increases, duration decreases and vice versa. The rate of change in duration is measured by convexity which is used in bond duration matching. Bond portfolio can be immunized from the effect of yield fluctuation through the use of both duration and convexity. We can relate bond price, coupon, yield, duration, and time to maturity by the following conclusions: 1) price is inversely related to yield but directly related to duration, 2) a decrease in yield raises price more than the same increase in yield lowers price, and 3) if yield equals coupon, then duration and time to maturity are directly related. FINDINGS :- Portfolio Management & Custodial Services The Portfolio Management Services Section (PMS) of State bank of India has been set up to handle investment and regulatory related concerns of Institutional investors functioning in the area of Social Security. The PMS forms part of the Treasury Dept. of State Bank of India, and is based at Mumbai. PMS was set up exclusively for management of investments of Social Security funds and custody of the securities related thereto. In the increasingly complex regulatory and investment environment of today, even the most sophisticated investors are finding it difficult to address day to day investment concerns, such as ,[object Object]

security selection quality considerations

conformity to policy constraints

investment returns The team manning the PMS Section consists of highly experienced officers of State Bank of India, who have the required depth of knowledge to handle large investment portfolios and address the concern of large investors. The capabilities of the team range from Investment Management and Custody to Information Reporting. MUMBAI: India’s largest bank — State Bank of India — is foraying into the international market to raise close to $1 billion, riding on the back of improved sentiment for Indian paper. SBI plans to raise between $700 million and $1 billion through this bond issue, the proceeds of which will be used to fuel the bank’s growth plans. SBI chairman OP Bhatt had recently said his bank, which accounts for one-fifth of the total deposits and credit in the banking sector, hoped to record a credit growth of 20% in 2009-10, although loan growth has been muted so far during the first few months of the current fiscal. MUMBAI (Reuters) - State Bank of India, the country's largest lender, plans to raise 180 billion rupees ($3.8 billion) through bonds by March 2010, the bank said on Tuesday, a day ahead of its 20-billion-rupee bond issue.

A project report on bond portfolio management with referance to state bank of india

Empfohlen

Empfohlen

Weitere ähnliche Inhalte

Was ist angesagt?

Was ist angesagt? (20)

Andere mochten auch

Andere mochten auch (11)

Ähnlich wie A project report on bond portfolio management with referance to state bank of india

Ähnlich wie A project report on bond portfolio management with referance to state bank of india (20)

Mehr von Projects Kart

Mehr von Projects Kart (20)

Kürzlich hochgeladen

Kürzlich hochgeladen (20)

A project report on bond portfolio management with referance to state bank of india