Riding the bond market
The recent hike in interest rate and CRR by the RBI has wrecked havoc with the bond market. We are all familiar with the inverse relationship between bonds and interest rates, but why is it so? And what should an investor's strategy be in a scenario of rising interest rates or falling interest rates?So let us start with a simple definition of a bond- A bond is a type of security that functions like a loan. Bonds are IOUs issued by private companies, municipalities or government agencies. When a bond is purchased, money is lent to the issuer—that is, the company, municipality or government agency that issued the bond. In exchange for the use of this money, the issuer promises to repay the amount loaned (the principal; also known as the face value of the bond) on a specific maturity date. In addition, the issuer typically promises to make periodic interest payments over the life of the loan.
After a bond is purchased, it may be traded. The price at which a bond trades, however, may differ from its face value. One reason bond prices fluctuate is due to changes in interest rates. Think of the relationship between bond prices and interest rates as opposite ends of a seesaw. When interest rates fall, a bond's value usually rises. When interest rates rise, a bond's value usually falls. Therefore, if a bond is sold before it matures, it may be worth more or less than the price paid for it. Take this example. Say you buy a bond when the prevailing market interest rates are 8%. So, a bond with a face value of Rs 1,000 on issue would pay Rs 80 a year in interest -usually in two half-yearly installments of Rs40. But if market interest rates were to rise to 10%, then who would want to buy such a bond? So, the market price of the bond would have to fall to a level where that fixed Rs80 annual payment were the equivalent of a 10% annual yield - in this case, the price would have to fall to Rs 800, so that the annual Rs80 payment would equal 10% of the purchase price of the bond. (Obviously, this matters only if the holder of the bond wants to sell it in the open market; if he or she wants to keep the bond to maturity, the price fluctuations exist only on paper). The opposite is true when interest rates decline.
The longer a bond's maturity, the more its price tends to fluctuate as market interest rates change. For example, a rise in interest rates will cause a larger drop in price for a 20-year bond than for an otherwise equivalent 10-year bond. However, longer-term bonds tend to fluctuate in value more than shorter-term bonds.
So what else effects bond prices? Credit risk, prepayment risk and inflation risk also effect bond prices. Credit risk refers to the creditworthiness of the bond issuer and its expected ability to pay interest and to repay its debt. If a bond issuer is unable to repay principal or interest on time, the bond is said to be in default. A decline in an issuer's credit rating, or creditworthiness, can cause bond mutual fund share prices to decline. That is why before investing it is necessary to review the credit rating of the borrower. This could range from Highest Quality, High Quality, Good Quality, Medium Quality, Speculative Elements, Speculative, More Speculative, Highly Speculative, In Default, Not Rated.
Maturity Risk means that the longer a bond's maturity, the further out it rests on the price side of the seesaw and the more its price tends to fluctuate as interest rates change. For example, a rise in interest rates will bring about a larger drop in price for a 20-year bond than for an otherwise equivalent 10-year bond. Prepayment risk is the possibility that a bond owner will receive his or her principal investment back from the issuer prior to the bond's maturity date. This can happen when interest rates fall, giving the issuer an opportunity to borrow money at a lower interest rate than the one currently being paid. (For example, a homeowner who refinances a home loan to take advantage of decreasing interest rates has prepaid the loan.) As a consequence, the bond's owner will not receive any more interest payments from the investment. This also forces any reinvestment to be in a market where prevailing interest rates are lower than when the initial investment was made. Inflation erodes the purchasing power of any investment. For example, Rs. 1,000 in a deposit account earns 9 percent interest, but inflation is 6 percent per year. Although this money will earn Rs 90 in interest after one year, inflation cuts the actual worth of this Rs 90 down to Rs Rs 84.60. In addition, the initial Rs1,000 will also erode by 6 percent to Rs 940. Therefore, after one year, the deposit account has a balance of Rs1,090, but due to inflation, it is only worth Rs 1,024.5 This is the effect of inflation risk.
To maintain an investment's value, its total return must keep pace with the inflation rate. A skillful trader can earn money by buying bonds at the top of the interest-rate cycle--and then selling at the bottom. The trouble is, those once-steady interest rates now bounce down and up quite quickly--and this new volatility makes bond trading riskier than ever.
So what should an investor's strategy be in times when the interest rates are rising. Well obviously he should try and take advantage of the rise and this he can do if he does not lock in his investments in long term maturities. This means that the interest rates of fixed deposits, savings accounts of banks and all those financial instruments you park your hard-earned money in, will stop falling in the short term and might rise in the long term. So, this means that these avenues of investment will become more attractive as compared to bond/debt funds, which typically might be carrying longer term maturity securities. So lets say if the investor expects the rates to go up then he should lock in his money into fixed income yielding deposits or bonds or bond mutual funds which have short maturity i.e.-3 months, six months etc. With interest rates expected to rise, people will no longer prefer a longer maturity portfolio.
In today's low interest-rate environment, where the chances are that the interest rates will go up before they go down much more, it makes sense to favor short-term or intermediate-term maturity portfolios even if you have a long-term horizon.
Aru Srivastava