In the annals of Investment folklore there is an old saying, if you want to make the most money, you should invest in stocks. But if you want to keep the money you made in stocks, you should invest in bonds.
We always consider Bonds as the most important asset class though it also has the lowest expected rate of return. Bonds are largely regarded as being lower-risk investments than shares, which is why they’re so popular with big institutions such as Banks, Provident Funds, Insurance and pension funds.
Bonds are important as they are a better indicator of wider macro signals and risk measures, rather than shares. Bonds and especially government securities tend to react very quickly to the macroeconomic signals and risk measures. Equity markets try to remain ahead of any earning and the economy uptrend; that is, they’re probably about six months ahead of any data indicating an economic recovery. Equities, in particular, can be very volatile and sometimes share prices are moved by factors that have nothing to do with interest, inflation or GDP growth rates, or economic/business cycles.
Basic Things to Know About Bonds
A bond is a type of investment that represents a loan between a borrower and a lender. With bonds, the issuer promises to make regular interest payments to the investor at a specified rate (the coupon rate) on the amount it has borrowed (the principal amount) until a specified date (the maturity date). Once the bond matures, the interest payments stop and the issuer is required to repay the face value of the principal to the investor.
Because the interest payments are made generally at set periods of time and are fairly predictable, bonds are often called fixed-income securities.
The maturity date of a bond is the date when the principal or par amount of the bond will be paid to investors, and the company’s bond obligation will end.
Bonds often are referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium or intermediate-term bonds generally are those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years.
Not all bonds reach maturity, even if you want them to. Callable bonds are common: They allow the issuer to retire a bond before it matures. Call provisions are outlined at the time of issuance of the bond itself.
A bond’s coupon is the annual interest rate paid to the bondholder, generally paid out annually or semi-annually on individual bonds. The coupon is always tied to a bond’s face or par value and is quoted as a percentage of par values. It is also referred to as the coupon rate, coupon percent rate and nominal yield.
Bonds that don’t make regular interest payments are called zero-coupon bonds. As the name suggests, these are bonds that pay no coupon or interest. Instead of getting an interest payment, you buy the bond at a discount from the face value of the bond, and you are paid the face amount when the bond matures.
Yield to Maturity (YTM)
Yield to maturity (YTM) is the most commonly used yield measurement. The yield to maturity (YTM) is a very meaningful calculation that tells you the total return you will receive by holding the bond until it matures. YTM equals all the interest payments you will receive (assuming you reinvest these interest payments at the same rate as the current yield on the bond), plus any gain (if you purchased the bond at a discount) or loss (if you purchased the bond at a premium) on the price of the bond. YTM is useful because it enables you to compare bonds with different maturity dates and coupon rates.
Coupon vs YTM
Fluctuations in interest rates usually have the biggest impact on the price of bonds – interest rates can be affected by many things, including a change in inflation rates. Generally speaking, bond prices move inversely to interest rates because the coupon rate usually remains constant through to maturity. If current interest rates are higher than the coupon rate, the bond is less attractive to investors and drops in value, since investors aren’t willing to pay as much for a series of lower coupon payments. Bond prices increase when the coupon rate is higher than current interest rate levels. To an investor who holds bonds through to maturity, price fluctuations may seem irrelevant.
Let us assume that a bond has a face value of Rs 100 with an 8% coupon rate. A coupon rate or nominal yield indicates that if you hold a bond from issuance to maturity, you are expected to receive the amount equal to the coupon rate every year and par value at maturity. This means that the investor will earn Rs 8 per annum on each bond he invests in.
Scenario1: Interest rates rise to 10%. Even so, the investor will continue to earn Rs 8 that is fixed and will not change. So to increase the yield to 10%, which is the current market rate of interest, the price of the bond will have to drop to Rs 80.
Scenario2: Interest rates fall to 6%. Again, the investor will continue to earn Rs 8. This time the price of the bond will have to go up to Rs 133.
The maturity of the bond matters. The greater the maturity – the longer the life of the bond – the stronger the effect with regards to gains and losses is of interest rates in the economy.
To estimate how sensitive a particular bond’s price is to interest rate movements, the bond market uses a measure known as duration.
Duration is a weighted average of the present value of a bond’s cash flows, which include a series of regular coupon payments followed by a much larger payment at the end when the bond matures and the face value is repaid.
If you know how to calculate the present value of the future cash flows, you will very well calculate the duration of the bonds. As an investor, it is good to know the calculation but it is better to understand the relationship among price, yield and modified duration of a bond.
ΔP = – MD * ΔY
Modified duration = Duration / (1 + yield)
P = Price
Y = yield
Let’s assume that modified duration of the bond is 3 years. So if the yield fell by 0.5%, the price would go up by 3 x 0.5% = 1.5%. If the yield rose by 0.5%, the price would fall by 1.5%.
Modified duration is a standard risk measure in bond fund management but it is important to remember that it is used only for small movements in yield.
Many people including legendary investor Warren Buffett has argued that bonds fail to protect investors’ purchasing power. When taxes and inflation are subtracted from bond returns, investors fail to gain wealth.
This is true if you hold your entire portfolio in cash or bonds, you run the risk of losing out to inflation. This is particularly a threat in the low-interest-rate environment. We don’t think bonds should be shunned. When held to maturity, bonds provide a consistent return of capital. Bonds also have low long-term correlations with stocks, making them a good diversifier. Bonds and shares are two important component of asset allocation and you can’t wish away any of them.