Bond / Debt Funds and the related confusion

This post is for all those Inquisitive Investors who need a brief idea on Debt Funds, Bonds FMP’s, MIP’s, CD’s, CP’s, Yield, Coupon and interest.

Read on… comments are welcome for a better elucidation of the above topics 

What is a debt fund?

An investment pool where the core holding are in the form of fixed income securities such as Corporate Debt (CP), Government Securities, Treasury Bills, Bank Debt (Commercial Deposit) and other kinds of securitized debt(s). The papers that denote different debt instruments depending upon the issuing authority like state government, Central Government, Companies and Banks are collectively known as Bonds.

Like the Capital of different companies is collectively called as 'Shares' same way debt issued by different institutions are called 'Bonds'. The way a share trader trades in Shares same way a Bond trader trades in Bonds. An Equity Mutual Fund invests in Shares same way a Debt Mutual Fund invest in Bonds. So a debt fund could is a Mutual Fund that buys and invest in Bonds. Mutual Funds are the widely used Investment pool hence we will be discussing only about Debt Funds managed by Mutual Funds.

Debt funds are generally differentiated on the type of bonds they hold, and type of maturities they trade in. A Liquid Fund can have an average maturity of anywhere between 20-90 days, where as an Income fund can have an Average Maturity of 15 years. Funds can hold pure Government securities or pure Public Sector Unit(PSU) bonds or a mix of both.  

Note: a debt fund is also known as fixed income funds as they strive to give fixed stream of returns over extended periods of time.

Debt Funds and their attributes

To understand about how debt funds work and their risk factors including their pricing and how it generates returns, there are certain characteristics about bonds that need to be explained first.

Bond?

A bond is a security or a contract that contains the borrowing agreement. A bond typically is an IOU agreement between the lender and the borrower. The type of bonds depends on the type of borrower and his credibility. When the government borrows money from the public it is called a G-sec bond. When a corporate accepts funds from the public as a loan it is called as debentures, Commercial Paper. The rating of a bond depends on the issuer/borrower of the bond, the better his repaying capacity the better his rating.   

Face Value?

Face value of a bond is also known as the par value, it is the amount that a holder of the bond gets when the bond matures. In most cases fresh bonds are issued at the face value, but there are instances in which bonds are also issued at a discount to its face value these are known as deep discount bonds. A misconception among many is that the face value of a bond is the price of the bond which is not true. Once a bond is issued at face value then the price of the bond depends upon the interest rates or yields prevailing in the market. Price of a bond can be above the face value or even below the face value.

Maturity of a bond

Bonds Maturity is the tenure of repayment for the borrower. Assuming you have taken a housing loan for 20 years then the tenure of the bond is 20 Years. Bonds tenure can be from as low as 1 day to as high as 99 years. An important fact to be noted when we discuss about the tenure of a bond is the risk; longer the tenure the more risky the bond will become as the investor will have to lock in his money for such a long time. During this period the interest rates could go up and the credit worthiness of the borrower could decline, hence a long tenure bond will always have a higher coupon in comparison to a shorter maturity one.

Coupons on Bonds

The amount of interest that the bondholder will receive- expressed as a percentage of the par value/face value is known as coupon. Thus, if a bond has a par value of Rs1000 and a coupon rate of 8%, the person holding the bond will receive Rs.80 a year. The bond will also specify when the interest is to be paid, whether monthly, quarterly, semi-annually, or annually. A fact to be noted is coupons and yields are not the same.

Zero Coupon Bonds are those that do not make any coupon payments. The issuer will pay back the par value at the end of the maturity. These bonds are bought at price which is well below the par value of the bond. Assuming a Zero Coupon Bond is issued at a par value of 1000 for a maturity of 1 year, now the lender technically pays only 920 to the borrower. At the end of 1 year the borrower will payback Rs 1000 to the lender.

The lender’s net yield is (1000-920)/920 = 8.69%. howzzat… you thought 8% right?

Yield on Bonds

Simplistically Yield is the return that you get on a bond. Yield may or may not be equal to the Coupon. In other words yield is the return a bond must offer in order to be worthwhile for an investor. Yields are usually taken as a basis for calculating the price of a bond.

Pricing of a bond

Bond prices changes daily and depends upon the prevailing yield in the market, which in turn is affected by the prevailing interest rates in the market. When interest rate rise the prices of bonds in the market fall thereby raising the yield of the older bonds and bringing them in line with newer bonds being issued. When interest rate fall the prices of bonds in the market rise thereby lowering the yield of the older bonds and bringing them in line with newer bonds being issued with lower coupons.

Duration

Duration is a measure of sensitivity of a bond’s price with interest rate movement. It is helpful in finding out the volatility of a fund. Bonds with high Duration experience greater increases in value when interest rates decline, and greater losses in value when interest rates increase, compared to bonds with lower Duration.

Example if a portfolio has a duration of 5 years, the portfolio’s value will decline about 5% for each 1% increase in interest rates—or rise about 5% for each 1% decrease in interest rates. Such a portfolio is less risky than one which has a 10-year duration. That portfolio is going to decline in value about 10% for each 1% rise in interest rates. The factor that affects duration is the maturity of the bond when the maturity of the bond increases the duration increases and vice versa.

The Eternal relation between Bond Price and Interest rates

Bond prices fall when interest rates rise and price rises when interest rates fall. If interest rates were to decline then newer bonds would be issued at lower interest rates than existing bonds. Consequently old bonds would be dearer and hence prices of these older bonds would rise. Similarly if interest rates were to rise then the value of old bonds would fall as newer bonds would bear higher interest rates. The traded price of a bond may thus differ from its face value.

The longer a bond’s period to maturity, the more its prices tend to fluctuate as market interest rates change. Let’s take an example if you buy a 10% GOI Bond at a face value of 100 then the yield will be 10% (Coupon / face value = Yield). Assuming due to RBI rate cuts the current yield on a GOI bond falls to 8% then value of the bond or its price rises (8% = 10/Price of Bond therefore bond price is 125). In a similar fashion if the yields rise due to inflation or any other factors to 12% then the Bond price would fall (Bond price= yearly coupon/yield which is 83.33).

To conclude buying bond is equal to lending money, for a G-Sec Bond the borrower is the Indian government. Bonds can give fixed returns and the capital is more or less assured at maturity. While buying a debt fund the dynamics change, the NAV of the debt fund could swing depending upon on the movement in interest rates. To insulate yourself from this risk I would suggest to always buy fixed income funds with a hold to maturity kind off structure or buy those debt funds with low average maturity. Debt funds with average maturity anywhere between 3 months to 18 months is a good buy to reap benefits on this high interest rate scenario as well as a essential diversification when compared to Equity markets.

Recommended Funds

1.       Templeton India Income Opportunities Fund

2.       HDFC High Interest Fund

3.       DSP Black Rock Short Term Fund

KYC a must for all Individual Mutual Fund Investors

From January 1, 2011, all categories of investors irrespective of amount of investment in Mutual Funds are required to comply with KYC norms under the Prevention of Money Laundering Act 2002 (PMLA) for carrying out the transactions such as new or additional purchase, switch transactions, new SIP registrations Change in Address and bank details.

  

Thus, with effect from 1st January 2011, any investor investing into mutual funds through the Investment Services Account would be required to be KYC compliant with CVL (CDSL Ventures Ltd) without which the transactions may be liable to be rejected by the respective mutual fund houses.

KYC is an acronym for 'Know your Client', a term commonly used for Client Identification Process This would be in the form of verification of identity and address, providing financial status, occupation and such other demographic information to CDSL Ventures Ltd. (CVL), a wholly owned subsidiary of Central Depository Services (India) Ltd. (CDSL).

KYC is just to get an Idea on are you a Legal Citizen of India making you eligible for investments. NRI’s are also required to complete the KYC requirements for eligibility to invest in Indian Markets.

The process of KYC is fairly simple all you need to do is download the single page form fill your Age, Address, DOB and occupation status. Provide valid proof for Identity as well as address and you are done with it. Below mentioned the link for downloading a KYC form. 

.http://www.cvlindia.com/include/pdf/KYC%20Individual.pdf 

Indian Inflation thanks to China & US

The article which I found on Bloomberg is an interesting read on the way countries are trying to protect their vested interest. This is not a bad thing, for long Kings, statesmen and even animals have been known to mark their territory and trying to protect them. 

The point is an increasingly global scenario were most of the economies are interdependent on each other and where there is free flow of capital things could get a bit tricky. 

It’s become commonplace to accuse the U.S. of exporting inflation to the rest of the world. After all, the dollar is the world’s reserve currency. International trade is conducted in dollars. Print too many of them, and inflation is sure to follow. 

Not so fast. The U.S. needs a partner in crime, a willing counterparty to import what the U.S. is selling. It has a perfect ally in the People’s Bank of China, which prints yuan to absorb the dollars that flow into the country in exchange for its exports. 

How is it, then, the Fed can export inflation to all these other countries? 

The Fed can print dollars, and those dollars may very well find their way into global commodities prices, emerging debt and equity markets or country-specific goods. That’s not inflation. No matter how many dollars the Fed prints, it cannot affect another country’s inflation unless that country is complicit in increasing its own money supply to prevent its currency from appreciating. 

China is making a choice to import inflation. (Actually, in pegging the yuan to the dollar, the PBOC is choosing to cede control over its domestic monetary policy to the Federal Reserve. Inflation is the result.) 

Whether a zero percent interest-rate policy is suitable for the U.S. is an open question. It’s not appropriate for a country like China, which grew 10.3 percent in 2010 and is faced with accelerating inflation, a property bubble and soaring money and credit growth. 

The PBOC has been raising reserve requirements and short- term interest rates, selling bills and setting caps on loan growth in an attempt to reduce liquidity and fight inflation. It has allowed the yuan to appreciate only gradually -- about 3 percent in the last six months -- even as China receives an average of $20 billion each month as a result of its trade surplus with the U.S. 

Of course, the choice not to import inflation isn’t quite as simple as trade-surplus countries allowing their currencies to appreciate. Exchange rates have lots of effects on the rest of the economy that a country may or may not be able to tolerate, China’s economy has grown 100-fold, in nominal terms, since Communist Party leader Deng Xiaoping introduced free-market policies in 1978. It has done that by adopting a mercantilist policy of selling more abroad than it buys, holding its exchange rate down to maintain that advantage. China keeps consumers poor so it can grow through mercantilism. Prices and wages eventually move up, making Chinese goods less competitive. In the long run, inflation will destroy any competitive edge China derived from its undervalued currency. 

Now the above was the brief view of a scenario between US$ and the Yuan, my point is what about India were do we stand. Inflation in our country is also soaring petrol prices are already up 20% in the last one year. Food price are up more than 100% in a year. We are also equally affected by the dollar overflow creating bubbles in our market. 

For me India has never taken any strong stance till now on any economic as well as political policy. We have always been a moderate government with little bit of this and that. Our economy is also like that not authoritarian nor capitalist, nor purely socialist. Hence we suffer. Of course there is an advantage and disadvantage. People say our central bank thought about all this and hence did not take any active decision on importing sophisticated financial products into our banking system. For me it is purely luck the time that goes behind every decision slowed us down and turned out to be lucky. 

It is not that we had not taken any decision against using structured debt products. Banks like ICICI had already had a few of these products under their belt. Our slow approach saved us. 

Same way, we have partially pegged ourselves to the dollar hence still under the influence of the US Federal reserve. But the point is we are not gaining from importing this inflation from US. 

We are not a country with net exports nor do we have any attractive competitive country advantage due to our lesser currency value. In spite of this we imported inflation. Leading to rise in product prices, wages and thereby loosing further due to our high cost exports when compared to China. The constant flow of capital has also led to creation of asset bubbles in the stock market and real estate. 

We are still an economy that needs cheap capital if RBI continues to raise rates to curb inflation. We are going to lose heavily in the long run. China and the US have clear cut policies; the former is hell bent on being the world’s largest economy and the later is trying to revive its dead white elephant of an economy. 

I am just wondering when India will have the fortitude to stand up for its economic policies and stop trying to adjust itself with shifting economic policies of the west. 

When will RBI create policies that could lead our country to economic independence and protect our interest instead of siding with the vested interest of the west?