Generate an ‘interest’ in ‘bonding’ it right

Many choose government bonds as they have the ‘sovereign guarantee’ which means they are backed by the government. But they carry lower coupons. Some corporate bonds offer very high coupons but the probability of coupons and principal getting honored by them is low. Therefore, it is called there exists Risk and Return trade-off

“Byaaj Ke Utaar Chadhaav Se, Prabhawit Hotaa ‘Bond’ Baazaar,

Byaaj Ghate Mooldhan Badhe, Badhe Byaj, Mool Me Hot Utaar”

Translation: Bond market gets impacted by movement of interest- rates. Softening increases its price, with hardening price depreciates.

A bond is simply a loan taken out by a company/ government. Instead of going to a bank, the company gets the money from investors who buy its bonds. In exchange for the capital, the company pays an interest (called coupon in bond parlance), which is the annual interest rate paid on a bond expressed as a percentage of the face value. The company pays the interest at predetermined intervals, either annually or semiannually and returns the principal on the maturity date, ending the loan.

Many different types of bonds are available in the Indian market. They are classified on the basis of issuer, coupon rates, and tenure.

Depending on the issued bonds, bonds come with varying interest rates and risks:

According to the issuer, bonds can be categorized into government, public sector undertakings (PSU) or corporate bonds.

According to the coupon, they can be fixed, floating or zero-coupon bonds.

Further, according to tenure, they can be categorized into short-term (1 to 5 years), intermediate term (5 to 12 years), and long-term bonds (more than 12 years).

A bond is a form of debt financing, and they are not the same thing as stocks where the investor get the ‘ownership’.

Market prices of debt securities change with movements in interest rates in the economy. Let’s assume you own a bond that yields 10 % coupon per annum. If the interest rate in the economy falls, say to 9%, new bonds issued in the market would offer this lower rate. To match this lower rate, there would be an increase in the prices of the bonds issued earlier as they have a higher coupon (interest) rate so that the current yield remains the same lower rate of 9%. Similarly, if the interest rate rises to, say 11%, the price of the bond will fall so that the new investor gets the same current yield.

Now, how do you choose a bond? The first parameter is risk. Many choosegovernment bonds as they have the ‘sovereign guarantee’ which means they are backed by the government. But they carry lower coupons. Some corporate bonds offer very high coupons but the probability of coupons and principal getting honored by them is low. Therefore, it is called there exists Risk and Return trade-off.

With a bit of due diligence, we can select some high rated bonds which will entail higher returns than the government bonds but safer than the bonds with low ratings. What if we find two bonds with the same risk profiles? We can use the concept of uration. Duration can measure how long it takes, in years, for an investor to be repaid a bond’s price by the bond’s total cash flows. Duration can also measure the sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates. Duration (also called the Macaulay duration) helps an investor evaluate and compare bonds independent of their time to maturity.

The second type of duration is called the Modified Duration. Unlike Macaulay duration, modified duration is not measured in years. Modified duration measures the expected change in a bond’s price to a 1% change in interest rates. The higher the modified duration, the greater will be the impact of an interest rate change.

While investing in fixed income securities, the following things like credit rating, maturity, liquidity, taxation etc. must be kept in mind in addition to rate of interest or coupon. For a risk-averse investor, safety should be the prime concern rather than the return. In the case of investment in listed bonds, tracking of the interest-rate cycle is also called for.

(The writer is senior vice-president, SBI Funds Management Ltd);(Translation from the original text and synopsis have been done by Abhijeet Bhushan, Group Head (Treasury), HK Group of Companies)