Description
In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity
BOND….But not James BOND....But of Course James Bond of Finance
Bond prices go up when interest rates go down! . Have you ever heard that and wondered how is it possible ? What goes behind the scene which makes it happen? It’s important for you to know this, because now a days there are enough financial products which depend on interest rates, for example Debt funds, Fixed Maturity Plans, Infrastructure Bonds and many products. In this article I will show you in simple language how bonds prices and interest rates are related. How interest rates and bonds prices are related ? You must have heard or read often that when Interest rates fall, bond prices go up and when interest rates rise, bond prices go down. Also in many articles you would have read a term “Interest rate Risk”, but always wondered why its is a “risk”. Let me give you a simple example . Suppose in the market the interest rates are around 10% , Now Ajay lends Rs 1,000 to Robert for 1 yr at the interest rate of 10% , which means Ajay will get Rs 100 as interest next year plus his initial 1,000 of principle , so Ajay will get back total Rs 1,100 at the end of 1 yr. Now suppose they sign a paper where all these terms and conditions are written and we call this paper as “BOND” . Who ever has this bond at the end can go to Robert and get Rs 1,100 by giving them that BOND paper. Now imagine two situations where interest rates move up and down and a third person called Chetan wants to buy the bonds after interest rates has moved. Lets see how bond prices move in both the cases here. Case 1 : Interest rates go down Suppose interest rates in market falls to 9% because of government policies or some other reasons (in our country RBI keeps change interest rates). Which means now if a person lends Rs 1,000 to some one, he can get only 9% as interest. But Ajay has a special bond! , which actually gives 10% return (also called as coupon rate) and not 9%. He is getting 1% more than what a new bond in market will give. Now if Chetan comes to Ajay and wants to buy this Bond from Ajay, Will Ajay give this bond at 1,000 ? No , This bond is worth more now, because this bond is giving more than what a normal bond in market can provide. What will be price Ajay can charge from Chetan ? It’s very simple maths. If Chetan goes to market and invests 1,000 , He will get 1,090 at the end of the year because interest rates are at 9% only. So how much should Chetan pay for the bond Ajay is holding as he will get Rs 1,100 with that bond. It’s a simple calculation => To get 1,090 at maturity , Chetan has to pay 1,000 in current condition. so .. => To get Rs 1 at maturity, Chetan has to pay 1,000/1,090 in current condition.
=> To get Rs 1,110 at maturity, Chetan has to pay 1,100 * 1,000/1,090 today = Rs 1,009.2 (approx). Which means as Ajay bond is giving 1,100 at the end , Its worth 1009.2 because interest rates moved down ! . So Ajay’s bond commands a premium of Rs 9.2 . You can see that 9% of 1,009.2 is equal to 90.8 and 1009.2 + 90.8 = Rs 1,100 which completes the equation . Case 2 : Interest rates go up In the same manner suppose interest rates move up to 12% in market from initial 10% . Now if a person lends Rs 1,000 to someone , he can get 1,120 at the end . Now Ajay’s bond is actually giving less than the new bonds in market . Why will some one pay 1,000 to Ajay to get 1,100 at the maturity , when they can lend the same money in market to get 1,120 at maturity , which is Rs 20 more . So now if a person has to buy Ajay’s bond they will pay a less price (discount) . Using the same process you saw above you can find out that the new value of bond will be 982.2 => To get 1,120 at maturity , Chetan has to pay 1,000 in current condition. so .. => To get Rs 1 at maturity, Chetan has to pay 1,000/1,120 in current condition. => To get Rs 1,110 at maturity, Chetan has to pay 1,100 * 1,000/1,120 today = Rs 982.2 (approx). Now both the examples I showed you was a very simple example, considering maturity after 1 yr. It was just to give you a brief idea about how interest rates and bond prices are interconnected. However in reality bond pricing is much more complex as maturity can be much more than 1 yr. It can be 5 yrs or 10-15 yrs (SBI bonds). In that case finding a new bond price become a little complex . However the overall funda remains the same . You see what are the future cash payments you can expect from the bond and relate it to the current interest rates and find out the Net present value of the bond in today’s term. We will not go into how the complex formula is arrived at , but I am giving you the formula below which you can use incase you want some time.
Bond prices and interest rates
Why do bond prices have an inverse relationship with interest rates? While it seems illogical that the value of a bond will fall when interest rates increase and rise when the interest rates fall, on close examination it makes sense. In this article we will explain to you how this works. For this, we will consider a zero coupon bond. A zero coupon bond does not pay coupons (or interest payments). These bonds return the accrued interest and principal (or par value) to the investor at the time of maturity. Zero coupon bonds derive their value from the difference between the purchase price and the par value (also the face value of the bond) paid at maturity. Let us assume that a hypothetical company had to raise money. For this it issues a zero coupon bond with a par value of Rs 1,000 and a coupon rate of 10% with a maturity of 2 years. The price at which the bond should trade is derived by the following formula.
Par Value -------------------------------------------------(1+coupon rate)^time for maturity
Using this formula (1000/(1+10%)^2), we arrive at a price of = Rs 826 Hence when issued, an investor will buy this bond at Rs 826 which is a discount to par value. This will be as only at this price, the investors will receive 10% returns on his investment when the bond matures. However, say the interest rates go up and the same company now has to pay 15% to raise money. A bond investor like an equity investor also seeks to maximise his return. Hence, in case an investor now buys the same bond, he will pay only Rs 756. This is because only at this rate will he be able to receive 15% on his investment. Hence when interest rates move up, the value of the bond falls. Similarly, if the interest rate falls to 5%, the bond’s value will increase. A 10% c oupon bond will be more attractive in the market as the bonds are now being issued by the same company with a coupon rate of only 5%. Hence an investor will pay more for the 10% bond. By our calculation, the bond will now be worth Rs 907
Here is the formula which you can use directly for Bonds New price after change in interest rate .
Where P = New Bond Price C = Yearly Interest received from the Bond i = New Interest rate N = Number of years for bond to mature M = Maturity value of Bond (generally its same as face value of Bond) Real Life Example Recently SBI came up with their Bonds issue. Lets say you invested Rs 1,00,000 in those bonds with maturity of 15 yrs and you are getting 9.95% interest on it and lets say that after 3 months SBI again comes up with another bond issue but this time they are giving interest of only 9% on those bonds. In this case your bonds will become more valuable now as your bonds give more interest that whats going on currently in the market . So now if you want to see your bonds on stock exchange it will quote a higher price which is P in the formula above and lets calculate it. Also lets see what are different variables in this case as per the formula above . P = This what we have to find . C = 9950 (9.95% of 1,00,000) i = 9% (new interest rate) N = 15 M = 1,00,000 (value you get at the end in maturity) Now if we use the formula above we will get P = 9950 * {( 1 + 1.09^15)/.09 } + {1,00,000 / (1.09^15) } P = 1,07,657.7 Which means you will fetch 7.6% premium in market because of decrease in interest rates . Now you find what will be bond price if the next SBI issue comes with 11% interest ? Tell me in comment section . The example I gave you is based on the formula only and small details are not taken care of which can further affect bond prices in market.
Note that in your life, you make many investments where interest rates come into picture but it’s behind the scenes . I will talk about some of those here .
Infrastructure bonds and other Bonds You know that we have infrastructure bonds offered in markets , Weather tax-saving or non-tax saving , most of those bonds are going to be traded on stock exchange, so if you bought any of those bonds in future when interest rates fluctuate , you know 2 things , what is the current interest rates and what is the final maturity value , using just 2 of these factors you can discover what is the current worth of those bonds and incase you want to buy/sell those bonds in stock market , you can command the right price . Fixed Maturity Plans and other Debt funds When you invest in Debt funds or Fixed Maturity plans , you give money to mutual funds and the fund manager uses this money to invest in bonds issued by Companies, government and other bodies . Based on the interest rates fluctuations in market they fetch good or poor returns based on their judgement . You as an investor would have more clarity about whats going on behind the scene . Just don’t be an ignorant investor who does not know how things work . What you should learn from this ? This article shows you how an investment can become attractive or unattractive based on interest rates, so incase you are planning to buy anything which depends on interest rates , better look at interest rates and study a bit on how it can move in future . If you are planning to buy some bonds today and there is anticipation in markets that interest rates are going to be raised at some time in near future , Your investments today in those bonds will go down in value because interest rates have moved up . At the same time if you feel interest rates will move down , It’s the time to buy those bonds ! This simple information is used by companies and govt to issue bonds , in the recent issue of SBI bonds even though SBI is giving 9.95% interest , if after 5th year they feel that interest rates can move down , they have kept their options open to kick you out of bonds and close the contract. Where as if the interest rates move higher , you can’t do nothing but you are stuck in those bonds for all 10 yrs , unless you choose you get rid of it by selling it on stock markets .
The yield curve In the previous article we had taken up some measures that quantify the returns on debt instruments. Going further we look into some of the factors that affect the pricing or the valuations of the debt instruments. (Kindly note the debt instruments considered in the article are G-secs and T-bills. Other instruments like debentures and zero coupon bonds are not included. ) The very purpose of understanding the factors affecting the yield is to be able to correlate what effect the change in these factors would bear on the price of the instruments. We begin this exercise by looking at a very important graph. This is a plot of the yield (YTM) on various debt instruments against the time to maturity. This is known as the yield curve. Under normal circumstances, bonds with longer time to maturity will offer a greater return as there is a far greater element of uncertainty and therefore, risk (high risk-high return). And of course the instruments of a shorter duration will offer lower returns. Thus, the yield curve is in a normal course of events upward sloping.
Fortnightly closing YTM for benchmark securities (16th July 2001 to 31st July 2001) Source: Debt to Date,SHCIL,Issue no.14 However, the yield curve’s slope changes as various factors affect the pricing of debt market instruments. The curve might become flat or even slope negatively. A negatively sloping yield
curve indicates that the short-term instruments are priced lower than those with longer duration to maturity. Therefore, the yield curve could give an indication about, which instruments are attractive and which are not in a particular market environment. Understanding the forces that shape the yield curve, investors can make qualified decisions in selecting bonds with maturities so as to get an optimal return under different environment. For example take a yield curve that is flat instead of the normal upward sloping curve. In such a scenario, if you were confident that normalcy would return to the markets, you should sell long-term bonds and buy short-term bonds. The monetary policy The government borrows money by issuing G-Secs (longer duration) and T-bills. The interest the government pays on short-term instruments is the benchmark for all financial activity in the country (this rate is considered to be close to risk free). After the rate cut in March the benchmark interest rate in India is 7%. Suppose the Reserve Bank feels that there is too much liquidity in the financial system and there is a threat that inflation may rise. In such a scenario the Reserve Bank will adopt a tight monetary policy. It therefore sells government bonds (and collects money), reducing the money availability in the system. In case the central bank wants to ease the monetary policy, it buys back the bonds, in effect infusing liquidity in the economy. The central bank can therefore effectively control the short-term interest rates and the lower end of the yield curve. When the markets expect the central bank to cut rates the short-term instruments become expensive as they continue to offer higher interest or coupon rates. Consequently, the yield declines, adjusting to the lower interest rate environment (the yield curve steepens). On the contrary when the expectations are that the central bank will increase interest rates the price of the debt instruments fall causing the yield to increase (the yield curve flattens). The central bank’s decision to cut interest rates or to increase it also depends on the economic scenario in the country. The central bank has to keep in mind two objectives - to promote economic growth and to keep inflation under control. If the growth prospects of the economy are good then investment activity will be buoyant, resulting in demand for money (to fund expansion). However, unchecked investment activity could lead to a heating up of the economy, giving rise to inflationary pressures. In such a scenario, the central bank needs to adjust the fast rise in demand to the slower growth in supply. The central bank does this by increasing the cost of money. When the cost of money is high, both investment and consumption demand suffer.
Economic growth Economic growth and its prospects affect the yield curve. This is because the monetary policy is largely influenced by the health of the economy. The growth prospects of the economy affect the allocation of capital. If there are little or no growth prospects, the demand for capital will be sluggish. Banks would be saddled with surplus funds, which would probably diverted to the debt markets. Also, in a slowing economy, banks themselves might not be comfortable giving loans to the industry for fear of accumulating bad debts. Consequently, the investment avenue that guarantees almost risk free returns is the Gsecs and T-bills. This drives up demand for debt instruments. Higher demand results in prices of debt instruments being marked up, implying that yields decline. On the other hand, when the growth prospects for the economy become brighter the demand for these instruments weakens. Fiscal policy The fiscal policy controls the government’s earnings and spending. If a government spends more than it earns it will incur a fiscal deficit. A higher fiscal deficit increases the risk of default by a government. Therefore, the interest rates in these countries are higher. Rising budget deficits cause the yield curve to be steep while falling budget deficits tend to flatten the curve. India Inc’s balance sheet However, in case a fiscal situation of a country looks precarious the short-term interest rates will tend to be much higher than long-term interest rates. The long-term interest rates will be relatively lower on hopes that the situation improves in the future. But if the fiscal deficit continues to rise then interest rates in the long term will be higher because the government will continue to borrow to meet its fiscal deficit, increasing the demand for money. The markets as a result would demand higher interest rates causing the prices for instruments to decline. Inflation Inflation affects both the long term and the short term yields. If the inflation is around 7% and the long-term yield is about 11%, the real rate of return is just 4%. Therefore, if inflation rises the real rate of return would decline causing the price of the instrument to head south and thereby increasing the yield. This causes the yield curve to flatten.
Attractiveness of debt markets The investors who have invested in the stock markets have gone through a bad phase considering that firstly there was the tech meltdown and then of course the scams that were unearthed. Also, with the badla system being banned the investors have only one avenue left where they can get almost risk free returns this has caused the demand for the debt instruments and therefore their prices to move up. However, it remains to be seen whether the demand is more of short-term instrument or for long-term instruments. In the first quarter of FY02, the gross fiscal deficit at Rs 422 bn was almost double compared to Rs 251 bn in the corresponding period in the previous year. The increase in fiscal deficit was due to over 40% drop in revenue receipts. The decline in revenue receipts was caused by a 54% dip in corporate tax collections, which was on account of lower earnings by corporates. This clearly points to the slowing economy. Also, the actual expenditure of the government at Rs 651 bn was higher by 14% compared to 1QFY01. The present scenario is one of uncertainty. In such an environment, the ‘assured returns’ of government securities may make investment sense. However, one must take a broader view in terms of the overall asset allocation before making a commitment to any one-asset class.
Risks associated with bond In our earlier articles, we had introduced debt market instruments and measures of valuing debt instruments (The different measures of debt). We had also looked into some of the factors, which affect the pricing and valuations of bonds ( The yield curve). Although debt market instruments offer safe returns, they are not entirely risk free. There are several risks associated, arising mainly from change in external factors. Change in interest rate is the most influential risk, which primarily affects bond prices. We had earlier analysed the impact of interest rate risk and effect of other factors like monetary policy, fiscal policy, economic growth and inflation on bond prices. The purpose of this article is to highlight some of the other market related risks, which also influence bond prices. Some of the key risks factors associated with bond valuations are listed as follows:
1. 2. 3. 4. 5. 6. 7. 8. 9.
Interest rate risk Reinvestment rate risk Yield curve risk Call and prepayment risk Credit risk Liquidity risk Exchange rate risk Risk associated with inflation and erosion of purchasing power Risk due to political & regulatory events and government actions
Interest rate risk: Since we had already mentioned about interest rate risk in our previous articles, we will not go in its detail analysis. But just to refresh our memories, there is an inverse relationship between changes in interest rates and bond prices. The value of a bond is the sum total of the present value of its fixed future cash flows, discounted at the appropriate current market interest rate. Therefore, when the interest rate increases, a bond's value drops and vice-versa. A bond with longer maturity and higher yield will normally have less impact on price due to change in interest rates. On the other hand, an instrument with shorter maturity and low yield will tend to have larger impact on its price. The price volatility for low maturity and low yield instrument would however be on the lower side, as future cash inflows are lower compared to bond with long maturity period. Maturity Date 22-Nov-07 15-May-06 26-Jul-03 1-Sep-02 13-Dec-10 22-Apr-05 24-May-13 Coupon Rate Last traded Years to Yield to (%) price (Rs) Maturity Maturity (%) 6.8 6.8 6.5 11.2 8.8 9.9 9 74 84.5 90.1 102.6 103.9 107.6 108.4 5.9 4.4 1.5 0.6 8.9 3.3 11.4 22.7 15.7 12 9.7 6.7 5.9 4.6
30-May-13 30-May-21
9.8 10.3
112.7 114.2
11.4 19.4
3.3 3
Source: NSE web site Let's take the practical example in order to understand the relationship between maturity, bond price and yield. As can be seen from the table above, bond having the highest yield to maturity (YTM) of 22.7% and longer duration (in this case 6 years) will be relatively more volatile compared to a bond having short maturity and low YTM (6.5% instrument having YTM of 12%). However, impact on price due to change in interest rate will be more on bond having a short maturity and low yield. Call and prepayment risk: The issuer can call a bond if the call price is below the theoretical market price due to falling interest rates. This is due to the fact that if interest rate declines issuer can raise fresh funds at lower interest rates and would repay the loans raised earlier carrying higher interest rates. Also, the possibility of a call limits or caps the potential for price appreciation (if interest rate falls bond price can rise near the call price and not more than that). In India bonds issued with call options are generally not traded in markets (not listed). IDBI Flexibond 1992 issue (interest rate of about 16.5%) is the latest example of issuer calling the bond. The bond was originally issued for 25 years tenure, with a put and call option after every five years. The decision of the institution has come in the wake of softer interest rate scenario. IDBI could now raise fresh funds by about 500 basis points lower than the earlier 16% debt. Thus before investing in a non-government bond, the investor should evaluate the terms given for call option by the issuer which is likely to impact investor's future cash inflow. Reinvestment risk: The bondholder is exposed to the risk of investing the proceeds of the bond (or coupon payments) at lower interest rates after the bond is called. This is known as reinvestment risk. The risk is intense for those investors who depend on a bond's coupon payments for most part of their returns. Reinvestment risk becomes more problematic with longer time horizons and when the current coupons being reinvested are relatively large. Home loan and personal finance companies are generally affected when home and auto buyers prepay their loans. In the lower interest rate environment, the finance companies get back their money sooner than expected, which adversely affects their future revenues. Credit risk: For a bond investor, there are primarily three types of credit risk: default risk, credit spread risk and downgrade risk.
Default risk is defined as the possibility that the issuer will fail to meet its obligations (timely payment of interest and principal) under the indenture. Credit spread risk is the excess return earned by a bond investor above the return on a benchmark, default free security (G-Sec). This is to compensate the investor for risk of buying a risky security. Interest rates on bonds issued by corporates are therefore generally higher compared to return from G-Secs. Yield on a risk bond = Yield on a default free bond + Risk premium Downgrade risk: It is the risk that a bond is reclassified as a riskier security by a credit rating agency. The rating agency considers many factors for evaluating the credit worthiness of a particular instrument. This includes the economic environment at large, the ability of the issuer to make good on its promise and the general political condition in the country. When an issue is re-categorized or its credit rating is changed, the yield adjusts immediately to reflect the new rating. Liquidity risk: It is the risk that represents the likelihood that an investor will be unable to sell the security quickly and at a fair price. Illiquid security will also have the risk of large price volatility. Quantitatively liquidity risk can be estimated through Bid-ask spread. Bid price represents the price at which dealers are willing to buy the security from traders/investors and ask price represents the price at which they are willing to sell the security to investors. The bid price is lower than the ask. The spread between these two prices is known as the bid-ask spread and it is used as a measure of a security's liquidity. High spreads signal an illiquid market. Investors like liquid markets so that they can buy and sell securities quickly and at a fair price. Liquidity may also improve as more participants actively engage in trading a security. For example, a 10.2% bond has the YTM of just 2.7%, but it is one of the most actively traded instruments with a longer maturity period. Thus it offers good liquidity to investors who can buy/sell the instrument easily. On the other hand instrument with a coupon rate of 10.8% with a maturity period of 13 years, although offers high YTM of 6.5%, has a relatively low liquidity. Maturity Date Coupon Rate Last traded Last traded Current Years to Yield to (%) qty (nos.) price (Rs) yield (%) Maturity Maturity (%) 11-Jun-10 11-Sep-26 11.5 10.2 2,500 1,500 115.5 115 10 8.9 8.4 24.7 3.5 2.7
24-Jun-06 19-May-15 5-Aug-11 19-Jun-08 23-May-03 21-May-05
13.9 10.8 11.5 12.1 11 10.5
1,200 100 54 50 45 28
121.4 108 117.1 116.4 99.8 110.4
11.4 10 9.8 10.4 11 9.5
4.5 13.4 9.6 6.4 1.4 3.4
2.8 6.5 2.7 3.6 11.1 5
Source: NSE web site Exchange rate risk: When bond payments (coupons/principal) are denominated in a currency other than the home currency of the bond holder, the investor bears the risk of receiving an uncertain amount when these payments are converted into the home currency. For example if rupee appreciates against the foreign currency (US$) of the bond payments, each US$ will be worth less in terms of rupee. This uncertainty related to adverse exchange rate movements in known as the exchange-rate risk or simply the currency risk. Inflation risk: It refers to the possibility that prices of general goods and services will increase in the economy. Since fixed coupon bonds pay a constant coupon, increasing prices erode the buying power associated with bond payments. This is known as the inflation risk. For example, if a risk free bond has a coupon rate of 7.5%, and prices increase at the rate of 4% per year, the investor's real return is 3.5%. Higher inflation rates result in a reduction of the purchasing power of bond payments (principal and interest). Event risk: These are generally related to the occurrence of a particular event and its impact on bond price. These can be listed as disasters, corporate restructuring, regulatory issues and political risk. Disasters (earthquakes or industrial actions) may impair the ability of a corporation to meet its debt obligations. Corporate restructuring (mergers, spin offs) may affect the obligations of the company by impacting its cash flow or the underlying assets that serve as a collateral. Regulatory issues such as environmental and other restrictions may impose compliance costs on the issuer, impacting its cash flow negatively. Political risk consisting of changes in the government or restrictions imposed on foreign exchange flows can limit the ability of the borrower to meet its foreign exchange obligations.
Volumes in the debt market are improving on increasing demand from banks. With credit growth in the system tinkering down, banks are investing in government securities over and above the minimum requirement for SLR. This has offered the good liquidity to the markets. Although, the bias is towards softer interest rates, retail investor should take into account the above risk factors before investing into a debt instrument. This is due to the fact that actual yield earned is determined by the price of a bond which is again the factor of the above listed risks. In our earlier articles, we had introduced debt market instruments and measures of valuing debt instruments (The different measures of debt). We had also looked into some of the factors, which affect the pricing and valuations of bonds ( The yield curve). Although debt market instruments offer safe returns, they are not entirely risk free. There are several risks associated, arising mainly from change in external factors. Change in interest rate is the most influential risk, which primarily affects bond prices. We had earlier analysed the impact of interest rate risk and effect of other factors like monetary policy, fiscal policy, economic growth and inflation on bond prices. The purpose of this article is to highlight some of the other market related risks, which also influence bond prices. Some of the key risks factors associated with bond valuations are listed as follows: 1. 2. 3. 4. 5. 6. 7. 8. 9. Interest rate risk Reinvestment rate risk Yield curve risk Call and prepayment risk Credit risk Liquidity risk Exchange rate risk Risk associated with inflation and erosion of purchasing power Risk due to political & regulatory events and government actions
Interest rate risk: Since we had already mentioned about interest rate risk in our previous articles, we will not go in its detail analysis. But just to refresh our memories, there is an inverse relationship between changes in interest rates and bond prices. The value of a bond is the sum total of the present value of its fixed future cash flows, discounted at the appropriate current market interest rate. Therefore, when the interest rate increases, a bond's value drops and vice-versa. A bond with longer maturity and higher yield will normally have less impact on price due to change in interest rates. On the other hand, an instrument with shorter maturity and low yield
will tend to have larger impact on its price. The price volatility for low maturity and low yield instrument would however be on the lower side, as future cash inflows are lower compared to bond with long maturity period. Maturity Date 22-Nov-07 15-May-06 26-Jul-03 1-Sep-02 13-Dec-10 22-Apr-05 24-May-13 30-May-13 30-May-21 Coupon Rate Last traded Years to Yield to (%) price (Rs) Maturity Maturity (%) 6.8 6.8 6.5 11.2 8.8 9.9 9 9.8 10.3 74 84.5 90.1 102.6 103.9 107.6 108.4 112.7 114.2 5.9 4.4 1.5 0.6 8.9 3.3 11.4 11.4 19.4 22.7 15.7 12 9.7 6.7 5.9 4.6 3.3 3
Source: NSE web site Let's take the practical example in order to understand the relationship between maturity, bond price and yield. As can be seen from the table above, bond having the highest yield to maturity (YTM) of 22.7% and longer duration (in this case 6 years) will be relatively more volatile compared to a bond having short maturity and low YTM (6.5% instrument having YTM of 12%). However, impact on price due to change in interest rate will be more on bond having a short maturity and low yield. Call and prepayment risk: The issuer can call a bond if the call price is below the theoretical market price due to falling interest rates. This is due to the fact that if interest rate declines issuer can raise fresh funds at lower interest rates and would repay the loans raised earlier carrying higher interest rates. Also, the possibility of a call limits or caps the potential for price appreciation (if interest rate falls bond price can rise near the call price and not more than that). In India bonds issued with call options are generally not traded in markets (not listed).
IDBI Flexibond 1992 issue (interest rate of about 16.5%) is the latest example of issuer calling the bond. The bond was originally issued for 25 years tenure, with a put and call option after every five years. The decision of the institution has come in the wake of softer interest rate scenario. IDBI could now raise fresh funds by about 500 basis points lower than the earlier 16% debt. Thus before investing in a non-government bond, the investor should evaluate the terms given for call option by the issuer which is likely to impact investor's future cash inflow. Reinvestment risk: The bondholder is exposed to the risk of investing the proceeds of the bond (or coupon payments) at lower interest rates after the bond is called. This is known as reinvestment risk. The risk is intense for those investors who depend on a bond's coupon payments for most part of their returns. Reinvestment risk becomes more problematic with longer time horizons and when the current coupons being reinvested are relatively large. Home loan and personal finance companies are generally affected when home and auto buyers prepay their loans. In the lower interest rate environment, the finance companies get back their money sooner than expected, which adversely affects their future revenues. Credit risk: For a bond investor, there are primarily three types of credit risk: default risk, credit spread risk and downgrade risk. Default risk is defined as the possibility that the issuer will fail to meet its obligations (timely payment of interest and principal) under the indenture. Credit spread risk is the excess return earned by a bond investor above the return on a benchmark, default free security (G-Sec). This is to compensate the investor for risk of buying a risky security. Interest rates on bonds issued by corporates are therefore generally higher compared to return from G-Secs. Yield on a risk bond = Yield on a default free bond + Risk premium Downgrade risk: It is the risk that a bond is reclassified as a riskier security by a credit rating agency. The rating agency considers many factors for evaluating the credit worthiness of a particular instrument. This includes the economic environment at large, the ability of the issuer to make good on its promise and the general political condition in the country. When an issue is re-categorized or its credit rating is changed, the yield adjusts immediately to reflect the new rating. Liquidity risk: It is the risk that represents the likelihood that an investor will be unable to sell the security quickly and at a fair price. Illiquid security will also have the risk of large price volatility. Quantitatively liquidity risk can be estimated through Bid-ask spread. Bid price
represents the price at which dealers are willing to buy the security from traders/investors and ask price represents the price at which they are willing to sell the security to investors. The bid price is lower than the ask. The spread between these two prices is known as the bid-ask spread and it is used as a measure of a security's liquidity. High spreads signal an illiquid market. Investors like liquid markets so that they can buy and sell securities quickly and at a fair price. Liquidity may also improve as more participants actively engage in trading a security. For example, a 10.2% bond has the YTM of just 2.7%, but it is one of the most actively traded instruments with a longer maturity period. Thus it offers good liquidity to investors who can buy/sell the instrument easily. On the other hand instrument with a coupon rate of 10.8% with a maturity period of 13 years, although offers high YTM of 6.5%, has a relatively low liquidity. Maturity Date Coupon Rate Last traded Last traded Current Years to Yield to (%) qty (nos.) price (Rs) yield (%) Maturity Maturity (%) 11-Jun-10 11-Sep-26 24-Jun-06 19-May-15 5-Aug-11 19-Jun-08 23-May-03 21-May-05 11.5 10.2 13.9 10.8 11.5 12.1 11 10.5 2,500 1,500 1,200 100 54 50 45 28 115.5 115 121.4 108 117.1 116.4 99.8 110.4 10 8.9 11.4 10 9.8 10.4 11 9.5 8.4 24.7 4.5 13.4 9.6 6.4 1.4 3.4 3.5 2.7 2.8 6.5 2.7 3.6 11.1 5
Source: NSE web site Exchange rate risk: When bond payments (coupons/principal) are denominated in a currency other than the home currency of the bond holder, the investor bears the risk of receiving an uncertain amount when these payments are converted into the home currency. For example if rupee appreciates against the foreign currency (US$) of the bond payments, each US$ will be worth less in terms of rupee. This uncertainty related to adverse exchange rate movements in known as the exchange-rate risk or simply the currency risk.
Inflation risk: It refers to the possibility that prices of general goods and services will increase in the economy. Since fixed coupon bonds pay a constant coupon, increasing prices erode the buying power associated with bond payments. This is known as the inflation risk. For example, if a risk free bond has a coupon rate of 7.5%, and prices increase at the rate of 4% per year, the investor's real return is 3.5%. Higher inflation rates result in a reduction of the purchasing power of bond payments (principal and interest). Event risk: These are generally related to the occurrence of a particular event and its impact on bond price. These can be listed as disasters, corporate restructuring, regulatory issues and political risk. Disasters (earthquakes or industrial actions) may impair the ability of a corporation to meet its debt obligations. Corporate restructuring (mergers, spin offs) may affect the obligations of the company by impacting its cash flow or the underlying assets that serve as a collateral. Regulatory issues such as environmental and other restrictions may impose compliance costs on the issuer, impacting its cash flow negatively. Political risk consisting of changes in the government or restrictions imposed on foreign exchange flows can limit the ability of the borrower to meet its foreign exchange obligations. Volumes in the debt market are improving on increasing demand from banks. With credit growth in the system tinkering down, banks are investing in government securities over and above the minimum requirement for SLR. This has offered the good liquidity to the markets. Although, the bias is towards softer interest rates, retail investor should take into account the above risk factors before investing into a debt instrument. This is due to the fact that actual yield earned is determined by the price of a bond which is again the factor of the above listed risks.
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In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity
BOND….But not James BOND....But of Course James Bond of Finance
Bond prices go up when interest rates go down! . Have you ever heard that and wondered how is it possible ? What goes behind the scene which makes it happen? It’s important for you to know this, because now a days there are enough financial products which depend on interest rates, for example Debt funds, Fixed Maturity Plans, Infrastructure Bonds and many products. In this article I will show you in simple language how bonds prices and interest rates are related. How interest rates and bonds prices are related ? You must have heard or read often that when Interest rates fall, bond prices go up and when interest rates rise, bond prices go down. Also in many articles you would have read a term “Interest rate Risk”, but always wondered why its is a “risk”. Let me give you a simple example . Suppose in the market the interest rates are around 10% , Now Ajay lends Rs 1,000 to Robert for 1 yr at the interest rate of 10% , which means Ajay will get Rs 100 as interest next year plus his initial 1,000 of principle , so Ajay will get back total Rs 1,100 at the end of 1 yr. Now suppose they sign a paper where all these terms and conditions are written and we call this paper as “BOND” . Who ever has this bond at the end can go to Robert and get Rs 1,100 by giving them that BOND paper. Now imagine two situations where interest rates move up and down and a third person called Chetan wants to buy the bonds after interest rates has moved. Lets see how bond prices move in both the cases here. Case 1 : Interest rates go down Suppose interest rates in market falls to 9% because of government policies or some other reasons (in our country RBI keeps change interest rates). Which means now if a person lends Rs 1,000 to some one, he can get only 9% as interest. But Ajay has a special bond! , which actually gives 10% return (also called as coupon rate) and not 9%. He is getting 1% more than what a new bond in market will give. Now if Chetan comes to Ajay and wants to buy this Bond from Ajay, Will Ajay give this bond at 1,000 ? No , This bond is worth more now, because this bond is giving more than what a normal bond in market can provide. What will be price Ajay can charge from Chetan ? It’s very simple maths. If Chetan goes to market and invests 1,000 , He will get 1,090 at the end of the year because interest rates are at 9% only. So how much should Chetan pay for the bond Ajay is holding as he will get Rs 1,100 with that bond. It’s a simple calculation => To get 1,090 at maturity , Chetan has to pay 1,000 in current condition. so .. => To get Rs 1 at maturity, Chetan has to pay 1,000/1,090 in current condition.
=> To get Rs 1,110 at maturity, Chetan has to pay 1,100 * 1,000/1,090 today = Rs 1,009.2 (approx). Which means as Ajay bond is giving 1,100 at the end , Its worth 1009.2 because interest rates moved down ! . So Ajay’s bond commands a premium of Rs 9.2 . You can see that 9% of 1,009.2 is equal to 90.8 and 1009.2 + 90.8 = Rs 1,100 which completes the equation . Case 2 : Interest rates go up In the same manner suppose interest rates move up to 12% in market from initial 10% . Now if a person lends Rs 1,000 to someone , he can get 1,120 at the end . Now Ajay’s bond is actually giving less than the new bonds in market . Why will some one pay 1,000 to Ajay to get 1,100 at the maturity , when they can lend the same money in market to get 1,120 at maturity , which is Rs 20 more . So now if a person has to buy Ajay’s bond they will pay a less price (discount) . Using the same process you saw above you can find out that the new value of bond will be 982.2 => To get 1,120 at maturity , Chetan has to pay 1,000 in current condition. so .. => To get Rs 1 at maturity, Chetan has to pay 1,000/1,120 in current condition. => To get Rs 1,110 at maturity, Chetan has to pay 1,100 * 1,000/1,120 today = Rs 982.2 (approx). Now both the examples I showed you was a very simple example, considering maturity after 1 yr. It was just to give you a brief idea about how interest rates and bond prices are interconnected. However in reality bond pricing is much more complex as maturity can be much more than 1 yr. It can be 5 yrs or 10-15 yrs (SBI bonds). In that case finding a new bond price become a little complex . However the overall funda remains the same . You see what are the future cash payments you can expect from the bond and relate it to the current interest rates and find out the Net present value of the bond in today’s term. We will not go into how the complex formula is arrived at , but I am giving you the formula below which you can use incase you want some time.
Bond prices and interest rates
Why do bond prices have an inverse relationship with interest rates? While it seems illogical that the value of a bond will fall when interest rates increase and rise when the interest rates fall, on close examination it makes sense. In this article we will explain to you how this works. For this, we will consider a zero coupon bond. A zero coupon bond does not pay coupons (or interest payments). These bonds return the accrued interest and principal (or par value) to the investor at the time of maturity. Zero coupon bonds derive their value from the difference between the purchase price and the par value (also the face value of the bond) paid at maturity. Let us assume that a hypothetical company had to raise money. For this it issues a zero coupon bond with a par value of Rs 1,000 and a coupon rate of 10% with a maturity of 2 years. The price at which the bond should trade is derived by the following formula.
Par Value -------------------------------------------------(1+coupon rate)^time for maturity
Using this formula (1000/(1+10%)^2), we arrive at a price of = Rs 826 Hence when issued, an investor will buy this bond at Rs 826 which is a discount to par value. This will be as only at this price, the investors will receive 10% returns on his investment when the bond matures. However, say the interest rates go up and the same company now has to pay 15% to raise money. A bond investor like an equity investor also seeks to maximise his return. Hence, in case an investor now buys the same bond, he will pay only Rs 756. This is because only at this rate will he be able to receive 15% on his investment. Hence when interest rates move up, the value of the bond falls. Similarly, if the interest rate falls to 5%, the bond’s value will increase. A 10% c oupon bond will be more attractive in the market as the bonds are now being issued by the same company with a coupon rate of only 5%. Hence an investor will pay more for the 10% bond. By our calculation, the bond will now be worth Rs 907
Here is the formula which you can use directly for Bonds New price after change in interest rate .
Where P = New Bond Price C = Yearly Interest received from the Bond i = New Interest rate N = Number of years for bond to mature M = Maturity value of Bond (generally its same as face value of Bond) Real Life Example Recently SBI came up with their Bonds issue. Lets say you invested Rs 1,00,000 in those bonds with maturity of 15 yrs and you are getting 9.95% interest on it and lets say that after 3 months SBI again comes up with another bond issue but this time they are giving interest of only 9% on those bonds. In this case your bonds will become more valuable now as your bonds give more interest that whats going on currently in the market . So now if you want to see your bonds on stock exchange it will quote a higher price which is P in the formula above and lets calculate it. Also lets see what are different variables in this case as per the formula above . P = This what we have to find . C = 9950 (9.95% of 1,00,000) i = 9% (new interest rate) N = 15 M = 1,00,000 (value you get at the end in maturity) Now if we use the formula above we will get P = 9950 * {( 1 + 1.09^15)/.09 } + {1,00,000 / (1.09^15) } P = 1,07,657.7 Which means you will fetch 7.6% premium in market because of decrease in interest rates . Now you find what will be bond price if the next SBI issue comes with 11% interest ? Tell me in comment section . The example I gave you is based on the formula only and small details are not taken care of which can further affect bond prices in market.
Note that in your life, you make many investments where interest rates come into picture but it’s behind the scenes . I will talk about some of those here .
Infrastructure bonds and other Bonds You know that we have infrastructure bonds offered in markets , Weather tax-saving or non-tax saving , most of those bonds are going to be traded on stock exchange, so if you bought any of those bonds in future when interest rates fluctuate , you know 2 things , what is the current interest rates and what is the final maturity value , using just 2 of these factors you can discover what is the current worth of those bonds and incase you want to buy/sell those bonds in stock market , you can command the right price . Fixed Maturity Plans and other Debt funds When you invest in Debt funds or Fixed Maturity plans , you give money to mutual funds and the fund manager uses this money to invest in bonds issued by Companies, government and other bodies . Based on the interest rates fluctuations in market they fetch good or poor returns based on their judgement . You as an investor would have more clarity about whats going on behind the scene . Just don’t be an ignorant investor who does not know how things work . What you should learn from this ? This article shows you how an investment can become attractive or unattractive based on interest rates, so incase you are planning to buy anything which depends on interest rates , better look at interest rates and study a bit on how it can move in future . If you are planning to buy some bonds today and there is anticipation in markets that interest rates are going to be raised at some time in near future , Your investments today in those bonds will go down in value because interest rates have moved up . At the same time if you feel interest rates will move down , It’s the time to buy those bonds ! This simple information is used by companies and govt to issue bonds , in the recent issue of SBI bonds even though SBI is giving 9.95% interest , if after 5th year they feel that interest rates can move down , they have kept their options open to kick you out of bonds and close the contract. Where as if the interest rates move higher , you can’t do nothing but you are stuck in those bonds for all 10 yrs , unless you choose you get rid of it by selling it on stock markets .
The yield curve In the previous article we had taken up some measures that quantify the returns on debt instruments. Going further we look into some of the factors that affect the pricing or the valuations of the debt instruments. (Kindly note the debt instruments considered in the article are G-secs and T-bills. Other instruments like debentures and zero coupon bonds are not included. ) The very purpose of understanding the factors affecting the yield is to be able to correlate what effect the change in these factors would bear on the price of the instruments. We begin this exercise by looking at a very important graph. This is a plot of the yield (YTM) on various debt instruments against the time to maturity. This is known as the yield curve. Under normal circumstances, bonds with longer time to maturity will offer a greater return as there is a far greater element of uncertainty and therefore, risk (high risk-high return). And of course the instruments of a shorter duration will offer lower returns. Thus, the yield curve is in a normal course of events upward sloping.
Fortnightly closing YTM for benchmark securities (16th July 2001 to 31st July 2001) Source: Debt to Date,SHCIL,Issue no.14 However, the yield curve’s slope changes as various factors affect the pricing of debt market instruments. The curve might become flat or even slope negatively. A negatively sloping yield
curve indicates that the short-term instruments are priced lower than those with longer duration to maturity. Therefore, the yield curve could give an indication about, which instruments are attractive and which are not in a particular market environment. Understanding the forces that shape the yield curve, investors can make qualified decisions in selecting bonds with maturities so as to get an optimal return under different environment. For example take a yield curve that is flat instead of the normal upward sloping curve. In such a scenario, if you were confident that normalcy would return to the markets, you should sell long-term bonds and buy short-term bonds. The monetary policy The government borrows money by issuing G-Secs (longer duration) and T-bills. The interest the government pays on short-term instruments is the benchmark for all financial activity in the country (this rate is considered to be close to risk free). After the rate cut in March the benchmark interest rate in India is 7%. Suppose the Reserve Bank feels that there is too much liquidity in the financial system and there is a threat that inflation may rise. In such a scenario the Reserve Bank will adopt a tight monetary policy. It therefore sells government bonds (and collects money), reducing the money availability in the system. In case the central bank wants to ease the monetary policy, it buys back the bonds, in effect infusing liquidity in the economy. The central bank can therefore effectively control the short-term interest rates and the lower end of the yield curve. When the markets expect the central bank to cut rates the short-term instruments become expensive as they continue to offer higher interest or coupon rates. Consequently, the yield declines, adjusting to the lower interest rate environment (the yield curve steepens). On the contrary when the expectations are that the central bank will increase interest rates the price of the debt instruments fall causing the yield to increase (the yield curve flattens). The central bank’s decision to cut interest rates or to increase it also depends on the economic scenario in the country. The central bank has to keep in mind two objectives - to promote economic growth and to keep inflation under control. If the growth prospects of the economy are good then investment activity will be buoyant, resulting in demand for money (to fund expansion). However, unchecked investment activity could lead to a heating up of the economy, giving rise to inflationary pressures. In such a scenario, the central bank needs to adjust the fast rise in demand to the slower growth in supply. The central bank does this by increasing the cost of money. When the cost of money is high, both investment and consumption demand suffer.
Economic growth Economic growth and its prospects affect the yield curve. This is because the monetary policy is largely influenced by the health of the economy. The growth prospects of the economy affect the allocation of capital. If there are little or no growth prospects, the demand for capital will be sluggish. Banks would be saddled with surplus funds, which would probably diverted to the debt markets. Also, in a slowing economy, banks themselves might not be comfortable giving loans to the industry for fear of accumulating bad debts. Consequently, the investment avenue that guarantees almost risk free returns is the Gsecs and T-bills. This drives up demand for debt instruments. Higher demand results in prices of debt instruments being marked up, implying that yields decline. On the other hand, when the growth prospects for the economy become brighter the demand for these instruments weakens. Fiscal policy The fiscal policy controls the government’s earnings and spending. If a government spends more than it earns it will incur a fiscal deficit. A higher fiscal deficit increases the risk of default by a government. Therefore, the interest rates in these countries are higher. Rising budget deficits cause the yield curve to be steep while falling budget deficits tend to flatten the curve. India Inc’s balance sheet However, in case a fiscal situation of a country looks precarious the short-term interest rates will tend to be much higher than long-term interest rates. The long-term interest rates will be relatively lower on hopes that the situation improves in the future. But if the fiscal deficit continues to rise then interest rates in the long term will be higher because the government will continue to borrow to meet its fiscal deficit, increasing the demand for money. The markets as a result would demand higher interest rates causing the prices for instruments to decline. Inflation Inflation affects both the long term and the short term yields. If the inflation is around 7% and the long-term yield is about 11%, the real rate of return is just 4%. Therefore, if inflation rises the real rate of return would decline causing the price of the instrument to head south and thereby increasing the yield. This causes the yield curve to flatten.
Attractiveness of debt markets The investors who have invested in the stock markets have gone through a bad phase considering that firstly there was the tech meltdown and then of course the scams that were unearthed. Also, with the badla system being banned the investors have only one avenue left where they can get almost risk free returns this has caused the demand for the debt instruments and therefore their prices to move up. However, it remains to be seen whether the demand is more of short-term instrument or for long-term instruments. In the first quarter of FY02, the gross fiscal deficit at Rs 422 bn was almost double compared to Rs 251 bn in the corresponding period in the previous year. The increase in fiscal deficit was due to over 40% drop in revenue receipts. The decline in revenue receipts was caused by a 54% dip in corporate tax collections, which was on account of lower earnings by corporates. This clearly points to the slowing economy. Also, the actual expenditure of the government at Rs 651 bn was higher by 14% compared to 1QFY01. The present scenario is one of uncertainty. In such an environment, the ‘assured returns’ of government securities may make investment sense. However, one must take a broader view in terms of the overall asset allocation before making a commitment to any one-asset class.
Risks associated with bond In our earlier articles, we had introduced debt market instruments and measures of valuing debt instruments (The different measures of debt). We had also looked into some of the factors, which affect the pricing and valuations of bonds ( The yield curve). Although debt market instruments offer safe returns, they are not entirely risk free. There are several risks associated, arising mainly from change in external factors. Change in interest rate is the most influential risk, which primarily affects bond prices. We had earlier analysed the impact of interest rate risk and effect of other factors like monetary policy, fiscal policy, economic growth and inflation on bond prices. The purpose of this article is to highlight some of the other market related risks, which also influence bond prices. Some of the key risks factors associated with bond valuations are listed as follows:
1. 2. 3. 4. 5. 6. 7. 8. 9.
Interest rate risk Reinvestment rate risk Yield curve risk Call and prepayment risk Credit risk Liquidity risk Exchange rate risk Risk associated with inflation and erosion of purchasing power Risk due to political & regulatory events and government actions
Interest rate risk: Since we had already mentioned about interest rate risk in our previous articles, we will not go in its detail analysis. But just to refresh our memories, there is an inverse relationship between changes in interest rates and bond prices. The value of a bond is the sum total of the present value of its fixed future cash flows, discounted at the appropriate current market interest rate. Therefore, when the interest rate increases, a bond's value drops and vice-versa. A bond with longer maturity and higher yield will normally have less impact on price due to change in interest rates. On the other hand, an instrument with shorter maturity and low yield will tend to have larger impact on its price. The price volatility for low maturity and low yield instrument would however be on the lower side, as future cash inflows are lower compared to bond with long maturity period. Maturity Date 22-Nov-07 15-May-06 26-Jul-03 1-Sep-02 13-Dec-10 22-Apr-05 24-May-13 Coupon Rate Last traded Years to Yield to (%) price (Rs) Maturity Maturity (%) 6.8 6.8 6.5 11.2 8.8 9.9 9 74 84.5 90.1 102.6 103.9 107.6 108.4 5.9 4.4 1.5 0.6 8.9 3.3 11.4 22.7 15.7 12 9.7 6.7 5.9 4.6
30-May-13 30-May-21
9.8 10.3
112.7 114.2
11.4 19.4
3.3 3
Source: NSE web site Let's take the practical example in order to understand the relationship between maturity, bond price and yield. As can be seen from the table above, bond having the highest yield to maturity (YTM) of 22.7% and longer duration (in this case 6 years) will be relatively more volatile compared to a bond having short maturity and low YTM (6.5% instrument having YTM of 12%). However, impact on price due to change in interest rate will be more on bond having a short maturity and low yield. Call and prepayment risk: The issuer can call a bond if the call price is below the theoretical market price due to falling interest rates. This is due to the fact that if interest rate declines issuer can raise fresh funds at lower interest rates and would repay the loans raised earlier carrying higher interest rates. Also, the possibility of a call limits or caps the potential for price appreciation (if interest rate falls bond price can rise near the call price and not more than that). In India bonds issued with call options are generally not traded in markets (not listed). IDBI Flexibond 1992 issue (interest rate of about 16.5%) is the latest example of issuer calling the bond. The bond was originally issued for 25 years tenure, with a put and call option after every five years. The decision of the institution has come in the wake of softer interest rate scenario. IDBI could now raise fresh funds by about 500 basis points lower than the earlier 16% debt. Thus before investing in a non-government bond, the investor should evaluate the terms given for call option by the issuer which is likely to impact investor's future cash inflow. Reinvestment risk: The bondholder is exposed to the risk of investing the proceeds of the bond (or coupon payments) at lower interest rates after the bond is called. This is known as reinvestment risk. The risk is intense for those investors who depend on a bond's coupon payments for most part of their returns. Reinvestment risk becomes more problematic with longer time horizons and when the current coupons being reinvested are relatively large. Home loan and personal finance companies are generally affected when home and auto buyers prepay their loans. In the lower interest rate environment, the finance companies get back their money sooner than expected, which adversely affects their future revenues. Credit risk: For a bond investor, there are primarily three types of credit risk: default risk, credit spread risk and downgrade risk.
Default risk is defined as the possibility that the issuer will fail to meet its obligations (timely payment of interest and principal) under the indenture. Credit spread risk is the excess return earned by a bond investor above the return on a benchmark, default free security (G-Sec). This is to compensate the investor for risk of buying a risky security. Interest rates on bonds issued by corporates are therefore generally higher compared to return from G-Secs. Yield on a risk bond = Yield on a default free bond + Risk premium Downgrade risk: It is the risk that a bond is reclassified as a riskier security by a credit rating agency. The rating agency considers many factors for evaluating the credit worthiness of a particular instrument. This includes the economic environment at large, the ability of the issuer to make good on its promise and the general political condition in the country. When an issue is re-categorized or its credit rating is changed, the yield adjusts immediately to reflect the new rating. Liquidity risk: It is the risk that represents the likelihood that an investor will be unable to sell the security quickly and at a fair price. Illiquid security will also have the risk of large price volatility. Quantitatively liquidity risk can be estimated through Bid-ask spread. Bid price represents the price at which dealers are willing to buy the security from traders/investors and ask price represents the price at which they are willing to sell the security to investors. The bid price is lower than the ask. The spread between these two prices is known as the bid-ask spread and it is used as a measure of a security's liquidity. High spreads signal an illiquid market. Investors like liquid markets so that they can buy and sell securities quickly and at a fair price. Liquidity may also improve as more participants actively engage in trading a security. For example, a 10.2% bond has the YTM of just 2.7%, but it is one of the most actively traded instruments with a longer maturity period. Thus it offers good liquidity to investors who can buy/sell the instrument easily. On the other hand instrument with a coupon rate of 10.8% with a maturity period of 13 years, although offers high YTM of 6.5%, has a relatively low liquidity. Maturity Date Coupon Rate Last traded Last traded Current Years to Yield to (%) qty (nos.) price (Rs) yield (%) Maturity Maturity (%) 11-Jun-10 11-Sep-26 11.5 10.2 2,500 1,500 115.5 115 10 8.9 8.4 24.7 3.5 2.7
24-Jun-06 19-May-15 5-Aug-11 19-Jun-08 23-May-03 21-May-05
13.9 10.8 11.5 12.1 11 10.5
1,200 100 54 50 45 28
121.4 108 117.1 116.4 99.8 110.4
11.4 10 9.8 10.4 11 9.5
4.5 13.4 9.6 6.4 1.4 3.4
2.8 6.5 2.7 3.6 11.1 5
Source: NSE web site Exchange rate risk: When bond payments (coupons/principal) are denominated in a currency other than the home currency of the bond holder, the investor bears the risk of receiving an uncertain amount when these payments are converted into the home currency. For example if rupee appreciates against the foreign currency (US$) of the bond payments, each US$ will be worth less in terms of rupee. This uncertainty related to adverse exchange rate movements in known as the exchange-rate risk or simply the currency risk. Inflation risk: It refers to the possibility that prices of general goods and services will increase in the economy. Since fixed coupon bonds pay a constant coupon, increasing prices erode the buying power associated with bond payments. This is known as the inflation risk. For example, if a risk free bond has a coupon rate of 7.5%, and prices increase at the rate of 4% per year, the investor's real return is 3.5%. Higher inflation rates result in a reduction of the purchasing power of bond payments (principal and interest). Event risk: These are generally related to the occurrence of a particular event and its impact on bond price. These can be listed as disasters, corporate restructuring, regulatory issues and political risk. Disasters (earthquakes or industrial actions) may impair the ability of a corporation to meet its debt obligations. Corporate restructuring (mergers, spin offs) may affect the obligations of the company by impacting its cash flow or the underlying assets that serve as a collateral. Regulatory issues such as environmental and other restrictions may impose compliance costs on the issuer, impacting its cash flow negatively. Political risk consisting of changes in the government or restrictions imposed on foreign exchange flows can limit the ability of the borrower to meet its foreign exchange obligations.
Volumes in the debt market are improving on increasing demand from banks. With credit growth in the system tinkering down, banks are investing in government securities over and above the minimum requirement for SLR. This has offered the good liquidity to the markets. Although, the bias is towards softer interest rates, retail investor should take into account the above risk factors before investing into a debt instrument. This is due to the fact that actual yield earned is determined by the price of a bond which is again the factor of the above listed risks. In our earlier articles, we had introduced debt market instruments and measures of valuing debt instruments (The different measures of debt). We had also looked into some of the factors, which affect the pricing and valuations of bonds ( The yield curve). Although debt market instruments offer safe returns, they are not entirely risk free. There are several risks associated, arising mainly from change in external factors. Change in interest rate is the most influential risk, which primarily affects bond prices. We had earlier analysed the impact of interest rate risk and effect of other factors like monetary policy, fiscal policy, economic growth and inflation on bond prices. The purpose of this article is to highlight some of the other market related risks, which also influence bond prices. Some of the key risks factors associated with bond valuations are listed as follows: 1. 2. 3. 4. 5. 6. 7. 8. 9. Interest rate risk Reinvestment rate risk Yield curve risk Call and prepayment risk Credit risk Liquidity risk Exchange rate risk Risk associated with inflation and erosion of purchasing power Risk due to political & regulatory events and government actions
Interest rate risk: Since we had already mentioned about interest rate risk in our previous articles, we will not go in its detail analysis. But just to refresh our memories, there is an inverse relationship between changes in interest rates and bond prices. The value of a bond is the sum total of the present value of its fixed future cash flows, discounted at the appropriate current market interest rate. Therefore, when the interest rate increases, a bond's value drops and vice-versa. A bond with longer maturity and higher yield will normally have less impact on price due to change in interest rates. On the other hand, an instrument with shorter maturity and low yield
will tend to have larger impact on its price. The price volatility for low maturity and low yield instrument would however be on the lower side, as future cash inflows are lower compared to bond with long maturity period. Maturity Date 22-Nov-07 15-May-06 26-Jul-03 1-Sep-02 13-Dec-10 22-Apr-05 24-May-13 30-May-13 30-May-21 Coupon Rate Last traded Years to Yield to (%) price (Rs) Maturity Maturity (%) 6.8 6.8 6.5 11.2 8.8 9.9 9 9.8 10.3 74 84.5 90.1 102.6 103.9 107.6 108.4 112.7 114.2 5.9 4.4 1.5 0.6 8.9 3.3 11.4 11.4 19.4 22.7 15.7 12 9.7 6.7 5.9 4.6 3.3 3
Source: NSE web site Let's take the practical example in order to understand the relationship between maturity, bond price and yield. As can be seen from the table above, bond having the highest yield to maturity (YTM) of 22.7% and longer duration (in this case 6 years) will be relatively more volatile compared to a bond having short maturity and low YTM (6.5% instrument having YTM of 12%). However, impact on price due to change in interest rate will be more on bond having a short maturity and low yield. Call and prepayment risk: The issuer can call a bond if the call price is below the theoretical market price due to falling interest rates. This is due to the fact that if interest rate declines issuer can raise fresh funds at lower interest rates and would repay the loans raised earlier carrying higher interest rates. Also, the possibility of a call limits or caps the potential for price appreciation (if interest rate falls bond price can rise near the call price and not more than that). In India bonds issued with call options are generally not traded in markets (not listed).
IDBI Flexibond 1992 issue (interest rate of about 16.5%) is the latest example of issuer calling the bond. The bond was originally issued for 25 years tenure, with a put and call option after every five years. The decision of the institution has come in the wake of softer interest rate scenario. IDBI could now raise fresh funds by about 500 basis points lower than the earlier 16% debt. Thus before investing in a non-government bond, the investor should evaluate the terms given for call option by the issuer which is likely to impact investor's future cash inflow. Reinvestment risk: The bondholder is exposed to the risk of investing the proceeds of the bond (or coupon payments) at lower interest rates after the bond is called. This is known as reinvestment risk. The risk is intense for those investors who depend on a bond's coupon payments for most part of their returns. Reinvestment risk becomes more problematic with longer time horizons and when the current coupons being reinvested are relatively large. Home loan and personal finance companies are generally affected when home and auto buyers prepay their loans. In the lower interest rate environment, the finance companies get back their money sooner than expected, which adversely affects their future revenues. Credit risk: For a bond investor, there are primarily three types of credit risk: default risk, credit spread risk and downgrade risk. Default risk is defined as the possibility that the issuer will fail to meet its obligations (timely payment of interest and principal) under the indenture. Credit spread risk is the excess return earned by a bond investor above the return on a benchmark, default free security (G-Sec). This is to compensate the investor for risk of buying a risky security. Interest rates on bonds issued by corporates are therefore generally higher compared to return from G-Secs. Yield on a risk bond = Yield on a default free bond + Risk premium Downgrade risk: It is the risk that a bond is reclassified as a riskier security by a credit rating agency. The rating agency considers many factors for evaluating the credit worthiness of a particular instrument. This includes the economic environment at large, the ability of the issuer to make good on its promise and the general political condition in the country. When an issue is re-categorized or its credit rating is changed, the yield adjusts immediately to reflect the new rating. Liquidity risk: It is the risk that represents the likelihood that an investor will be unable to sell the security quickly and at a fair price. Illiquid security will also have the risk of large price volatility. Quantitatively liquidity risk can be estimated through Bid-ask spread. Bid price
represents the price at which dealers are willing to buy the security from traders/investors and ask price represents the price at which they are willing to sell the security to investors. The bid price is lower than the ask. The spread between these two prices is known as the bid-ask spread and it is used as a measure of a security's liquidity. High spreads signal an illiquid market. Investors like liquid markets so that they can buy and sell securities quickly and at a fair price. Liquidity may also improve as more participants actively engage in trading a security. For example, a 10.2% bond has the YTM of just 2.7%, but it is one of the most actively traded instruments with a longer maturity period. Thus it offers good liquidity to investors who can buy/sell the instrument easily. On the other hand instrument with a coupon rate of 10.8% with a maturity period of 13 years, although offers high YTM of 6.5%, has a relatively low liquidity. Maturity Date Coupon Rate Last traded Last traded Current Years to Yield to (%) qty (nos.) price (Rs) yield (%) Maturity Maturity (%) 11-Jun-10 11-Sep-26 24-Jun-06 19-May-15 5-Aug-11 19-Jun-08 23-May-03 21-May-05 11.5 10.2 13.9 10.8 11.5 12.1 11 10.5 2,500 1,500 1,200 100 54 50 45 28 115.5 115 121.4 108 117.1 116.4 99.8 110.4 10 8.9 11.4 10 9.8 10.4 11 9.5 8.4 24.7 4.5 13.4 9.6 6.4 1.4 3.4 3.5 2.7 2.8 6.5 2.7 3.6 11.1 5
Source: NSE web site Exchange rate risk: When bond payments (coupons/principal) are denominated in a currency other than the home currency of the bond holder, the investor bears the risk of receiving an uncertain amount when these payments are converted into the home currency. For example if rupee appreciates against the foreign currency (US$) of the bond payments, each US$ will be worth less in terms of rupee. This uncertainty related to adverse exchange rate movements in known as the exchange-rate risk or simply the currency risk.
Inflation risk: It refers to the possibility that prices of general goods and services will increase in the economy. Since fixed coupon bonds pay a constant coupon, increasing prices erode the buying power associated with bond payments. This is known as the inflation risk. For example, if a risk free bond has a coupon rate of 7.5%, and prices increase at the rate of 4% per year, the investor's real return is 3.5%. Higher inflation rates result in a reduction of the purchasing power of bond payments (principal and interest). Event risk: These are generally related to the occurrence of a particular event and its impact on bond price. These can be listed as disasters, corporate restructuring, regulatory issues and political risk. Disasters (earthquakes or industrial actions) may impair the ability of a corporation to meet its debt obligations. Corporate restructuring (mergers, spin offs) may affect the obligations of the company by impacting its cash flow or the underlying assets that serve as a collateral. Regulatory issues such as environmental and other restrictions may impose compliance costs on the issuer, impacting its cash flow negatively. Political risk consisting of changes in the government or restrictions imposed on foreign exchange flows can limit the ability of the borrower to meet its foreign exchange obligations. Volumes in the debt market are improving on increasing demand from banks. With credit growth in the system tinkering down, banks are investing in government securities over and above the minimum requirement for SLR. This has offered the good liquidity to the markets. Although, the bias is towards softer interest rates, retail investor should take into account the above risk factors before investing into a debt instrument. This is due to the fact that actual yield earned is determined by the price of a bond which is again the factor of the above listed risks.
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