Pages

Thursday, January 27, 2011

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

No comments:

Post a Comment